Is Inflation Dead?

[Based on a speech delivered at the Mises Institute Supporters Summit, Palm Springs, California, February, 27, 1998.]

Wall Street remains constantly worried about two forces in American economic life, inflation and deflation. These days, fear of one does not necessarily exclude fear of the other. It seems Wall Street worries about inflation on Monday, Wednesday, and Friday. On Tuesday and Thursday, it worries about deflation. Or perhaps it worries about both at the same time.

Just what is the concern? Of course, inflation is one of the most destructive forces in all of human history. In order for an economy to function, money must be sound and its value must be honestly come by. For most of human history, soundness and honesty were guaranteed because money was just another name for the most valuable commodity, namely gold. Gold was ideal money because it was portable, durable, divisible, fungible, and scarce. Above all, scarce.

Gold has been money throughout most of our nation’s history. The government had little to no control over its supply and therefore its value. But around 1913–1918, in the midst of wartime, the foundation of money in gold began to be frittered away. Over the decades, the link became progressively less secure until, in 1973, the last remnants of the gold standard were done away with. If you put a dollar in a mattress in 1970, and pulled it out today, it would be worth less than a quarter.

Why? The monetary authorities have conducted a 35-year war against the sound dollar, which is precisely what we would expect given that the dollar no longer has any link to gold. The result has been theft on a grand scale. In fact, the government has extracted more from us in inflation than it has in tax increases over this same period. The government and its friends, and not the American people, benefit from inflation, for reasons I’ll explain shortly.

The demise of the gold standard is what made this extortion possible. Under a gold standard, there are strict limits on how much money can be created. Under the paper money standard, there are no limits. It always surprises me when I talk to college students, businessmen, and even to bankers, that not everyone understands this. They do not understand that there is no gold backing up the nation’s currency at all. There is no limit on how much of it must be created by the government and the banking cartel. Thus there is no limit to the extent to which money can continue to be watered down by monetary authorities. The only real restraint on monetary growth today is fear of a backlash by the financial community.

But Wall Street rarely takes the long view. So when inflation worries begin to dominate the market, it is not the fear of what further monetary depreciation might mean to American families that is the primary concern. Rather, traders are often concerned about the Federal Reserve’s response to renewed inflation. They are concerned the Fed might raise interest rates in an effort to counter inflation tendencies. And higher interest rates mean less borrowing, less credit expansion by the banking system, and thus represent a potential end to the decade-long party on Wall Street.

And what about the threat of deflation? This term, which hasn’t been heard in public for many years, first started being drummed lately when the price indexes first recorded a drop in selected consumer and producer prices. In common parlance, dating back to the Great Depression, deflation is supposed to be as much a threat to economic stability as inflation. The reasons the financial markets fear it have as much to do with the new uncertainties widespread deflation introduces, as much as they have to do with the real effects of deflation.

What are the real effects of deflation? A common myth is that it leads to lower profitability, and possibly even recession or depression. Is this true? A good way to tell is to set aside macroeconomic data like the consumer and producer price index, and look at a particular industry. Consider the price of computer hardware. For 20 years, the prices of computers have been falling while quality has been rising, and memory and speed have increased at a breakneck pace. Yet the industry is also among the most profitable.

Falling prices typically signal rising prosperity, just as they did in the latter half of the 19th century. In fact, if we had a truly free market coupled with a gold standard of sound money, falling prices would become the norm. You might be able to keep that dollar in your mattress and pull it out 25 years later only to discover it has more purchasing power than it had when you first squirreled it away. Sadly, this is not a luxury any of us has yet experienced. Even in the midst of all this talk about deflation, we have yet to see any kind of secular slide in prices that has lasted longer than a few weeks.

Part of the reason for this is that Washington apparently hates and fears lower prices. A few years ago, the price of beef took another tumble, causing ranchers around the country to worry about their own profitability. They lobbied Washington, as people are apt to do these days, and persuaded the secretary of agriculture to intervene. He bought up millions of dollars of what the ranchers called excess beef and gave it away to the poor for free.

As a beef lover, I would have loved to have benefited from low priced beef, and would have been even happier to get it for free. Sadly, I have not benefited from the secretary of agriculture’s actions. He was effectively stealing the benefit of lower prices from consumers and handing it over to a special interest group, all at the behest of well-heeled lobbyists in Washington.

I mentioned the Great Depression earlier. This is typically attributed to the falling price level of the 1930s, as if this were a cause of general economic downturn. In fact, falling prices were the one aspect of the Depression that helped mitigate the effects of a deep productivity crash that was brought about and sustained by government intervention in the price system. Falling prices meant that the dollars that people did own were becoming more and more valuable over time. But Washington, in its infinite wisdom, worked for the better part of a decade to pump the price level back up again, thereby ensuring that the real cause of the depression would not be addressed.

Before we leave the general topic of what is inflation, let me say a few words about the great CPI controversy. Early in the second term of the Clinton administration, Treasury Department and Fed officials began to wonder whether the inflation indexes being used to calculate inflation were really telling the truth. They announced that they were pretty sure that the CPI overestimates inflation by nearly a percentage point, or perhaps by as much as two points.

Now, consider what this would mean. The Bureau of Labor Statistics employs thousands of people to do nothing but examine prices paid for goods and services at all levels of industry. They calculate data from every conceivable source, and present it in myriad ways to the public. They break down the data in every conceivable way. But somehow, said the Clinton administration, in the voice of Stanford University’s Michael Boskin, along the way, mistakes are being made. The Bureau of Labor’s statisticians are overestimating inflation.

The question to ask Boskin is: how can you know for sure? To say that you know the BLS is making a mistake is also to say that you know with certainty what the correct inflation rate is. You have to have a benchmark to say that something doesn’t measure up. And if Boskin knew the truth, why not just abolish the BLS once and for all? If we need to know any economic data, we could just email Boskin, and he could consult his astrologer or swami or whomever he relies on for his revelations. Paying him half-a-million per year would save taxpayers billions.

In justifying his view, Boskin spent less time explaining his methodology than attacking the BLS’s own. He pointed out that it doesn’t make very much sense to aggregate prices that are stable and fixed—say for instance those of commodities—with those that change because of technological shifts or changes in relative scarcities. For example, what if I decided to calculate the 10-year inflation rate using three goods: private-school tuition, handheld calculators, and gasoline. I might end up with an index number of 0. Yet that conceals an enormous amount of information. And let’s say I want to throw in the price of real estate in Greenwich Village. We might get a soaring rate of inflation.

Boskin is right that the inflation rate is highly dependent on precisely what is in and what is out. It is difficult to adjust for price changes that come about from technology. The basket of goods that is included in the CPI is constantly changing, but not because science necessitates this. It changes because the BLS watches politics very carefully, and politics necessitates that the government always generate a lower and lower inflation rate.

The purpose of all this data collection is to discover the mysterious and highly elusive thing called the price level. The trouble is that there ain’t no such thing as a price level. Prices do not move up and down like the sea level. They always move relative to each other and in odd and unpredictable ways. Monetary inflation causes many if not most of them to rise, but calculating to what extent is a very tricky business. The only thing we can know for sure about monetary inflation is that it waters down the purchasing power of our money, and does so in an insidious and deadly way. Try to make a science out of finding out precisely how much, and you are headed for trouble.

Economists who favor monetary manipulation have a good reason to always talk about prices instead of purchasing power. It helps distract attention away from the real culprit, the real source of inflation. It’s not a mysterious rise and fall of the price level that can be more precisely measured by better data collection. In fact, the cause of inflation is not mysterious at all. It consists of the nation’s central bank adding to the stock of dollars in the economy by artificial means. The Fed can do this in three ways: lowering the discount rate, buying assets on the open market, and lowering the reserve ratio on bank deposits.

It is impossible to think about the nature of inflation and monetary manipulation in general without understanding what the Fed is all about. If you like conspiracy theories, you’ll love the history of the Fed. When talking about the Fed as a conspiracy against the public interest, however, we are not really talking about theory. We are talking real-world history. When the Fed was set up before World War I, it was designed by the banking and corporate elites, mostly consisting of a collaborative effort between the Morgan and the Rockefeller financial empires, with one purpose in mind: to make possible a more elastic currency. What does elastic currency mean? Well, let’s just say it’s something we would all like to have on a household level. Can’t pay the bills? If your household income is elastic, you just add a zero or two to your bank ledger. Elastic effectively means the ability to print more money when it turns out that you haven’t managed your accounts well.

That is precisely what the Fed was founded to make possible. It cartelized the banking system and allowed for coordinated inflation and credit expansion. It cut the necessary minimum reserve requirements, provided added bailout guarantees, and allowed banks to pyramid loans on top of Fed reserves. This was a tremendous benefit to the banking industry, and to the government which needed financing to enter the world war, but it forecast disaster for the soundness of currency. After the Great Depression, the same elites conspired again to institute new protections for the banking industry, giving us Glass-Steagall, deposit insurance, and watering down the gold standard ever more.

For most of the second half of the 20th century, a debate has raged about who precisely is to blame for inflation. This debate usually began with the assumption that if one party is not to blame it is the Federal Reserve. It is not only Greenspan who has a reputation as a great inflation fighter, but every previous Fed chairman. They are all described in the usual monetary histories as hard-nosed opponents of inflation. But how can this be? There is only one force that can cause the purchasing power of existing dollars to systematically decline, and that force is an expansion of the existing dollar stock through artificial means. There is only one power on earth that brings that about and that is the Federal Reserve.

Has some sneaky guy at the Fed been coming in after hours, after all the members of the board of governors have gone home, to print up money, buy and sell assets, raise and lower discount rates, and generally subsidize certain banks at the expense of others? Not at all. This has been a systematic policy. Large banks enjoy having the power to inflate for the same reason the counterfeiter values his printing machine. And in this, the Fed and its banks work hand in hand with the government.

The loss of the value in the dollar benefits debtors, and there’s no bigger debtor than the federal government. An elastic currency permits the expansion of debt to a huge extent, and makes it possible for the government to be the one and only entity that can make an ironclad promise to make good on its debts. Thus, its bonds carry no risk premium. They will always be paid, but always at someone else’s expense.

Not that the Fed has always intended to bring about large-scale monetary depreciation. It can set out to expand credit without warrant, and to grow the money supply to bring about an economic boom, but the consequences of those actions are not felt immediately and they are not always predictable. Moreover, the Fed is always anxious to separate itself from the effects of its policies.

Even today, Greenspan the Great frequently goes before Congressional committees and solemnly declares to what extent he thinks current rates of economic growth risk setting off inflation. But economic growth itself cannot set off inflation. Economic growth is neither a necessary nor sufficient cause for inflation. In fact, given the economists’ famous equation of exchange, economic growth tends to make goods and services cheaper, since the same amount of money is doing more work.

Why does Greenspan mislead people? The Fed always wants to avoid the tail of price inflation pinned on its own behind. In this, it shares an interest with government generally. Government blames unions. It blames businessmen. In the next round of price inflation, it will undoubtedly blame the soaring stock market, and the regular Americans who threw caution to the wind to invest in booming stocks.

There are generally four schools of thought on whether price inflation is good or bad for the economy. The first is the Keynesian School, which has generally celebrated inflation as a means of bringing markets back into equilibrium when they have been thrown out by the business cycle. In the Keynesian theory, you can reduce unemployment by increasing inflation. You can reduce inflation, but only if you are willing to tolerate higher unemployment. In the choice between people and money, people won every time ... by losing sound money.

Of course this tradeoff ended up being shown to be completely mythical. There is no relationship between inflation and unemployment. Developments of the mid-1970s, in which inflation and unemployment moved up together, dealt a substantial blow to the theory. And today, we’ve witnessed dramatic declines in both; the theoretical apparatus behind Keynesian macroeconomics lies in tatters.

But the soundness of economic theories alone does not determine whether it is useful for the power elite. Keynesian economic theory was well supplemented by a leftist theory that favored redistribution of all wealth, especially taking from producers and giving to nonproducers. Inflation does this, as well as taxation and the welfare state. It punishes savers and makes economic calculation difficult. Inflation shortens time horizons of people in society and thus weans them of bourgeois values. It punishes enterprise with capital and rewards those with debt. This is why egalitarians have always celebrated inflation, and why you are more likely to hear the case for inflation being made by a socialist than a believer in free enterprise.

Yet not all backers of inflation favor redistribution and leftism. The Supply-Siders are great on the need for tax cuts. But if you look at the works of Jude Wanniski, the politics of Jack Kemp, or the recommendations of the editorial page of the Wall Street Journal, you see a single fallacy repeated again and again: economic growth must be backed by monetary growth. Or put in an even more dangerous phrase: restrictive monetary growth holds back economic growth. This is merely another version of the old fallacy that prosperity can come from the printing press.

In a slightly different way, the Chicago School or Monetarist approach advocates a fixed rate of growth for the money supply, neither undershooting nor overshooting the rate of economic growth and thereby achieving a stable price level. Now, as we already discussed, the notion of a stable price level is unachievable. The very nature of prices is that they adjust up and down, relative to each other, to reflect changes in resources, tastes, and technology.

So this supposed ideal of stable money is not only impossible to achieve, but it robs people of the opportunity to experience a rising purchasing power of money. The Monetarist plan also imposes a kind of collateral damage on the economy that the theory doesn’t take account of. All new money injections distort the pricing signal of the interest rate. It causes some industries to undertake borrowing and business expansion they would not otherwise undertake. The new money works as a subsidy for some kinds of projects but not to others. As a result, even the Monetarist proposal sets in motion an artificial boom in some sectors of the economy.

Monetarism can be particularly dangerous in periods of deep recession, when economists of this school typically recommend gunning the money supply, as Milton Friedman recently did with respect to Japan. But gunning the money supply does nothing to correct the underlying structural problems that lead to business downturns in the first place. What an economy in recession needs more than new money is time and freedom. Time and freedom to clean out bad investments, time and freedom for wages to adjust, and time and freedom for the investment sector to align itself with the spending and savings sectors.

But what I’m speaking about here relates more to business cycles than inflation as such. And in order to understand them both, we need a richer and more complete view of the monetary side of the economy. That is where we turn to the writings of Murray Rothbard, Ludwig von Mises, F.A. Hayek, and the Austrian School of economics generally. For most of the 20th century, the Austrian School fought against monetary depreciation and for the gold standard. Only the Austrian School accurately predicted the consequences of fiat money and warned against the perils of inflation, not only its effect but also its cause.

The Age of Greenspan is considered to be one of sound money and low inflation. But consider a more fundamental change that has taken place in the monetary regime in the last decade. The Federal Reserve has long considered the banking system to be too big to fail. But with Greenspan, many more institutions have been added to the list. He intervened in 1987 to pull the stock market up from failure. He has intervened several times since then to bolster buying in the bond market and in the commodity futures market. During the Mexican peso crisis, he committed resources from the Fed to propping up the investments of US banks in Mexico, and then later combed the halls of Congress agitating for a bailout. He intervened after the dot-com bust and September 11. Finally, he has been the major force behind arguing for an expansion of the IMF, along with an implicit promise to bail out the IMF should its resources run dry.

In effect, Greenspan has instituted a too-big-to-fail doctrine for Wall Street and even whole governments. The consequence of this is to dramatically subsidize the willingness of traders and governments to take risks. They can safely assume a bailout will be forthcoming. It is difficult to imagine a more dangerous move on the part of any central banker. If you wonder about the future of inflation, I consider this to be a very strong indicator that we are not done with it yet.

What should the US do now? We should enjoy whatever deflation we can get right now. The government should not try to sustain high prices on any goods or services, but rather let them fall. That will allow us to prepare for a time when the dollar faces a challenge as the world reserve currency, and the monetary expansion of the last 10 years comes home to roost.

If we want to eliminate inflation forever, there is an easy step we can take. We can resecure the dollar to its historical foundation in gold and suppress the issuance of any more artificial money and credit. We could separate the monetary regime from the State entirely, and build a firewall between the dollar and politics. Only that step will provide permanent protection.

Until then, I would not suggest we become sanguine about the prospects of inflation, but prepare ourselves, not only for another bout, but also for the shock that comes with the realization that the laws of economics have not been repealed after all.