What the Fed Has Done and Is Doing to Us

0:00...among the publications of such august and stodgy economic think tanks as the American Enterprise Institute and the National Bureau of Economic Research. As your title suggests, these articles delineate chilling scenario of the American economy. Not only do they all contend that deflation is close at hand, but they also assert in common two other propositions. First, that the effects of deflation are an unmitigated disaster for economic activity and consumer welfare, and second, that the Federal Reserve system needs to take prompt action to head off such impending devastation to the economy. In particular, they argue that the Fed must dexterously shift gears and become a deflation fighter rather than the supposedly staunch and valiant inflation fighter it has been for the last two decades.

0:55A few authors even despair of whether the Fed is now constitutionally capable of making such a shift, as if any central bank in history would be unwilling or unable to create massive quantities of new money at the drop of a hat. Most of the growing host of deflation-phobes prudently leaves the precise details of the impending deflationary debacle to our imagination, with vague references to the Great Depression in the U.S. in the early 1930s, or to the experience of Japan since 1998. However, others, such as market pundit Donald L. Luskin, a self-proclaimed un-reconstructed supply-sider, delight in conjuring up warred deflationary scenarios. According to Luskin, deflation is, quote, going to be a world of hurt.

1:41If you thought inflation was a nightmare, wait until you live with a deflation. Prices of everything eventually go down. Geez, I thought that would be great. I hope everything goes down to what Nicholas Murray Rothbard used to say. Stocks, real estate, wages, the whole thing. You're a little poorer every day. And if you're in debt, then you're really in trouble. You'll have to make those same mortgage payments even though the value of your house is going down every month. But that doesn't mean that deflation is any bed of roses for lenders either. Sure, it's nice to have locked in a stream of payments and money that will buy you more and more apples and paperclips and houses as prices collapse. The only ones who are worse off are the creditors who took part in generating the inflationary credit, that is the banks, and those profligate firms and consumers that borrowed and spent it.

2:43So I don't cry for them. Regardless of whether they indulge in such rhetorical excesses or whether they dispassionately state their case in formal academic jargon, however, contemporary deflation-phobes fail to analytically distinguish between the melange of different phenomena that are commonly jumbled together under the current name of deflation. Indeed, academic macroeconomists are the most likely of all to be blind to this conceptual muddle because modern macroeconomics was born of John Maynard Cain's obsessive deflation phobia, especially with regard to money wage rates. As a result, they are not inclined to disentangle and give a coherent account of the separate economic processes designated as deflationary. Nor are they able to figure out which kinds of deflationary processes are benign and represent an improvement of economic efficiency and welfare, and which kinds are malign and distort monetary calculation and impair economic productivity and well-being.

3:43Fortunately, Austrian monetary theory, developed primarily by Ludwig von Mises and Murray Rothbard, provides us with the means to cut through the tangle of deflation-phobic fallacies that we have recently been bombarded with. In what follows, I will carefully define inflation, I will then use Austrian monetary theory both to identify and analyze the different kinds of deflation and to distinguish between deflations that are natural and benign products of a free market economy and compulsory deflation that represents a gross and maligned violation of property rights, a deflation which no one talks about but which is now taking place in Argentina. Everyone calls it responsible austerity measures. Before World War II, when the terms inflation and deflation were used in academic discourse or everyday speech, they generally referred to increases or decreases in the stock of money respectively.

4:36A general rise in prices was viewed as one of the several consequences of inflation of the money supply. Likewise, a decline in overall prices was viewed as one effect of deflation of the money supply. Under the influence of the Keynesian Revolution, however, the meaning of these terms began to change after the mid-1930s. By the 1950s, the definition of inflation as a general rise in prices and of deflation as a general fall in prices became firmly entrenched in academic writings and popular speech. We can ignore here whether or not this change in usage lends itself to conceptual clarity and analytical precision. The point is that today when professional economists or members of the lay public utter or write the term deflation, They invariably mean a decline in the overall prices of commodities and services purchased by the average consumer as reflected in the price index such as the CPI.

5:29Movements in the price of consumer goods are relevant for identifying the existence and degree of inflation or deflation because consumer goods are the final output and rationale of all economic activity. Moreover, as Carl Menger, the founder of Austrian Economics, has taught us, the prices of the myriads of intermediate and original inputs into the production process, broadly categorized as capital goods, labor and natural resources, are ultimately determined by a market imputation process, starting with the prices of consumer goods. Thus, when economists, business forecasters and Alan Greenspan scrutinize indexes of input prices, such as the producer price index or indexes of raw commodities prices, they do so because they incorrectly believe that changes in these indexes are predictors of future changes in general consumer prices, as if input prices determine product prices rather than the other way around.

6:31Defined as a general fall in consumer prices, deflation implies an increase in the value or purchasing power of the monetary unit. In the US, an increase in the amount of consumer goods that can be purchased for a dollar. Now, there are a number of different factors that tend to increase the value of the dollar. These deflationary factors and the processes they initiate may be benign or maligned, good or bad, with respect to economic efficiency, productive activity and consumer welfare. depending on whether they result from the voluntary choices of laborers, capitalists, entrepreneurs and consumers or the coercive intervention of a government central bank such as the Fed. As we shall see below, while the deflation-phobes have bemoaned the imaginary evils of deflationary scenarios that are actually benign, they have completely ignored the one instance of deflation that has actually materialized and is truly malign.

7:26According to Austrian theory, the value of money, which is the inverse of overall consumer prices, is determined like the individual prices of its component consumer goods by supply and demand. An increase in the value of a dollar and a corresponding decline in overall dollar prices may thus proceed either from an expansion of the demand for or contraction of the supply of money or a combination of both. There are four basic causes of deflation, two operating on the demand side and two on the supply side of the money relation. The economic processes associated with these factors may be categorized as growth deflation, cash building deflation, bank credit deflation and confiscatory deflation.

8:12I will analyze each in turn below and then appraise its effect on economic efficiency and consumer welfare. Let me start with growth efficiency. One component of the demand for money is the total quantities of the various commodities and services that people supply to the market in exchange for money. The aggregate supply of goods therefore constitutes what Austrians call the exchange demand for money, because by selling goods, including their own labor services, people are exercising a demand to acquire money. Hence, if supplies of goods in the economy increase, due for example to increased saving and investment in additional capital goods, and to technological improvement, as is the usual case in the historical market economy, then all other things equal, including the supply of dollars, their producers will be induced by competition to offer more units of the product for a dollar, and the exchange value of the dollar will be bid up. This means that on the other side of the market, consumers will need to give fewer dollars to obtain a given good and therefore a price deflation will occur.

9:19This is precisely what occurred in the past three decades with respect to products of the electronics and high tech industries such as hand calculators, video game systems, personal computers and DVD players. As a consequence of rapid technological improvement and its embodiment in additional capital goods, labor productivity increased phenomenally in these These industries driving down per unit costs of production and increasing profit margins. Since the resulting expansion of the supplies of goods forthcoming from these industries outstripped the expansion of the supply of dollars during this period, the effect was a spectacular drop in the prices of PCs, for example, and a corresponding rise in the dollar's purchasing power in terms of computing power. Note that this substantial price deflation in the high-tech industries did not impair and in fact facilitated the enormous expansion of profits, productivities and outputs in these industries.

10:12The price deflation that was observed in the past three decades in selected high growth industries, however, was not an unprecedented or even unusual occurrence. In fact, historically, the natural tendency in the industrial market economy under commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus, throughout the 19th century and up until the First World War, a mild deflationary trend prevailed in industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the U.S. from 1880 to 1896, the wholesale price level fell by about 30 percent or by 1.75 percent per year, while real income rose by about 85% or around 5% per year.

11:06So we had economic growth and deflation. This deflationary trend was only interrupted during periods of major wars, such as the Napoleonic Wars in Europe and the American Civil War, because the belligerent governments invariably financed their war spending by printing paper fiat money. Furthermore, note that the fallen prices and average production costs of consumer goods occurring during the growth process does not necessarily entail a decline in the nominal price of labor. If the supply of labor is fixed, money wage rates remain constant, while real wage rates rise to reflect the increase in the productivity of labor. Since the purchasing power of every dollar earned rises with the decline of consumer prices. Needless to say, economics as well as common sense tells us that the effect of such price deflation on economic activity and consumer welfare is entirely benign, because it is the result of the voluntary exchanges of property titles among resource owners, capitalists, entrepreneurs and consumers.

12:08These transactions generate a natural increase in the value of money that is a necessary complement to the growth of real wealth and income and the greater satisfaction of human wants that they provide. Okay, let me talk a little bit about hoarding, which I call cash building deflation. Although a handful of mainstream economists might be persuaded that price deflation associated with economic growth is benign, they would all scoff at the view that hoarding, a second factor tending toward price deflation, enhances economic efficiency and welfare. Hoarding occurs when an individual deliberately chooses to reduce his current spending on consumer goods and investment assets below his current income, preferring to add the unspent income to its cash balance held in the form of currency and immediately spendable checking and savings deposits at banks.

13:02However, hoarding is nothing but an increase in what is called a cash balance demand for money. That is, the average amount of money that the individual desires to keep on hand over a period of time. It usually stems from a more pessimistic or uncertain attitude towards the future, of the Future, caused possibly by the onset of a recession, a natural disaster or the imminent prospect of war. Under such circumstances, market participants appraise the value of the services yielded by a dollar in hand more highly than before, relative to the services of consumer goods or the interest yield on investment goods that can be currently purchased for the dollar. All other things equal, including the number of dollars in existence, This increase in the demand to hold money will result in the bidding up of the market value of the dollar in terms of goods.

13:54A pervasive price inflation will result, characterized by a reduction in the flow of dollar spending and dollar income. But the deflationary process caused by hoarding is also benign and productive of greater economic welfare. is initiated by the voluntary choices of some money holders to refrain from exchanging their title to their money assets on the market in the same quantities as they had previously. However, with the supply of money fixed, the only way in which this increased demand to hold money can be satisfied is for each dollar to become more valuable, so that the total purchasing power represented by the existing supply of money increases. This is precisely what price deflation accomplishes. An increase in aggregate monetary wealth or the real supply of money in order to satisfy those who desire additional cash balances.

14:45Now let me talk a little bit about bank credit deflation. There are two major factors that have historically operated on the supply of money to produce price deflation. Okay, so now we're talking about the supply side of money. The most familiar is a decline in the supply of money that results from a collapse or contraction of fractional reserve banks that are called upon by their depositors en masse to redeem their notes and demand deposits in cash during financial crises. Before World War II, bank runs generally were associated with the onset of recession and were mainly responsible for the deflation that always characterized recessions. What is called bank credit deflation typically came about when depositors lost confidence that banks were able to continue redeeming the titles, represented by the bank notes and checking account balances, to the property they had entrusted to the banks for safekeeping and which the banks were contractually obliged to redeem upon demand.

15:47This property was usually gold and silver money, and fractional reserve banks were not able to distort their contractual obligations to all its rightful owners at once because they had created multiple titles to this property in the course of their lending operations. This meant that their outstanding stock of redeemable notes and demand deposits were expanded to a large multiple of a commodity money reserve they kept on hand. During financial crises, bank runs caused many banks to fail completely and their notes and deposits to become worthless. In the case of other banks, the threat that their depositors would suddenly demand cash payments all at once was sufficient to induce them to reduce their lending operations, to build up their ratio of reserve to note and deposit liabilities in order to stave off failure.

16:33Both of these factors resulted in a large contraction of the money supply, and given a constant demand for money, a corresponding increase in the value of money. After national banks took legal custody of the public's gold deposits, which occurred in the US shortly after the Fed was established in 1914, The Central Bank itself usually engineered bank credit deflation during financial crises provoked by its previous inflationary policy in order to protect these gold deposits and to avert depositors' loss of faith in the entire banking system. Once again, our judgment must be that deflation, even when caused by a contraction of bank credit amidst numerous bank failures, has a salutary effect on the economy and enhances the welfare of market participants.

17:20For is initiated by a voluntary and contractual redemption of property titles to money by bank depositors, who perceive that the fractional reserve banks are no longer functioning to safely and securely store their cash balances. When any firm that trades on its trustworthiness, be it a financial services firm, an armored car company or a law firm, loses the confidence of its customers or clients that it is operating in their best interests, It will be rapidly purged from the market by an adjustment process that reallocates resources and improves the welfare of consumers. Bank credit deflation represents just such a benign and prerogative market adjustment process. In fact, in the era before the 1930s, when the natural flexibility of prices and wage rates prevailed and was not impeded by legal constraints, bank credit deflations in the US were swift and devoid of severe economic dislocations.

18:13Let me briefly review one episode. In the fall of 1839, there occurred a financial crisis in the U.S. which resulted from a massive expansion of the money supply during the 1830s, initially stimulated by the legally privileged Second Bank of the United States. From the peak of the business cycle in 1839 to its trough in 1843, the money supply contracted by about one-third, 34%. That's as much as occurred during the first four years of the Great Depression. Almost one-quarter of the nation's banks collapsed, including the Bank of the United States, and wholesale prices fell by 42%. Despite, or rather because of, the massive deflation of prices, real GNP and real consumption actually increased during this period by 16% and 20% respectively.

19:04So income was going up more slowly than before, but it was going up during this massive bank credit deflation. However, real investment did decline during the period by 23%, which was a benign development because the malinvestments of the previous inflationary boom needed to be liquidated. Now let me talk about a bad kind of deflation, confiscatory deflation. Not all types of price deflation are the outcome of benign market processes, however. There does exist a maligned form of deflation, coercively imposed by governments and their central banks, that violates property rights, distorts market processes and lowers economic welfare. This kind of deflation involves an outright confiscation of people's cash balances by the entrenched political bureaucratic class.

19:49Alas, confiscatory deflation has been almost completely ignored by the deflation-phobes, despite the fact that it has occurred quite a few times in the last two decades, in Brazil, the former Soviet Union, and Argentina in the 1980s, in Ecuador two years ago, and currently once again in Argentina. In fact, one of the few contemporary economists to identify and condemn confiscatory deflation as a malign form of deflation was Murray Rothbard. Deflation is imposed upon the economy by the political authorities as a means of obstructing an ongoing bank credit deflation that threatens to liquidate an unsound financial system built on fractional reserve banking. Its essence is an abrogation of bank depositors' property titles to their cash stored in immediately redeemable checking and savings accounts.

20:39A glaring example of confiscatory deflation is the current situation in Argentina. In In 1992, after yet another bout of hyperinflation, Argentina pegged its new currency, the peso, to the US dollar at the rate of 1 to 1. In order to maintain this fixed peso-dollar peg, the Argentine Central Bank pledged to freely exchange dollars for pesos on demand and to back its own liabilities, consisting of peso notes and commercial bank reserve deposits, almost 100% by dollars. Unfortunately, this arrangement, while it inspired confidence in international lenders because of IMF and U.S. approval and their implicit bailout guarantee, did not prevent the massive and inflationary bank expansion as investment dollars flooded into the country, they found their way into the central bank which was then able to create additional peso reserves.

21:40The latter were given to the fractional reserve bank system, which was then able to inflate bank credit by multiplying bank deposits on top of each new dollar or peso of reserves. As a result, Argentina's money supply increased at an average of 60% per year from 1991 through 1994, during the so-called currency war that is so beloved by the supply-siders in the Wall Street Journal. After declining to less than 5% for 1995, the growth rate of the money supply shot up to over 15% in 1996 and nearly 20% in 1997. With the peso overvalued as a result of the increasingly inflated domestic product prices and foreign investors losing confidence that the peso would not be devalued, The influx of dollars ceased and the inflationary boom came to a screeching halt in 1998 as the money supply increased by about 1% and the economy went into recession.

22:45In 1999, the money supply shrank slightly. In 2000, the money supply shrank by almost 20%. The money supply continued to contract at a double-digit annual rate through June 9, 2001. In 2001, domestic deposits began to lose confidence in the banking system and a bank credit deflation began in earnest as the system lost 17% or $14.5 billion worth of deposits. On Friday, November 30th alone of 2001, $700 million of deposits were withdrawn from Argentine banks. Even before the Friday bank run, the central bank only possessed $5.5 billion of reserves, ultimately backing $70 billion worth of dollar and convertible peso deposits.

23:33In response, on Saturday, December 1st, President Fernando de la Rua and his economy minister, Domingo Cavallo, announced a policy that amounted to confiscatory deflation to protect the financial system and maintain the fixed peg to the dollar. Specifically, cash withdrawals from banks were to be limited to $250 per depositor per week for the next 90 days, and all overseas cash transfers exceeding $1,000 were to be strictly regulated. Anyone attempting to carry cash out of the country by ship or by plane was to be interdicted. Finally, banks were no longer permitted to issue loans in pesos only in dollars, which were exceedingly scarce. Depositors were still able to access their bank deposits to make payments by check or or debit cards. Nonetheless, this policy was a crushing blow to poor Argentines who did not possess debit or credit cards and who hold mainly bank deposits not accessible by check. Predictably, Cavallo's cruel and malign confiscatory deflation developed a severe blow to cash businesses such as retail trade and according to one report, quote,

24:39brought retail trade to a standstill. This worsened the recession and riots and looting Soon broke out that ultimately cost 27 lives and millions of dollars of damage to private businesses. These events caused the state of siege to be declared and eventually forced President De La Rua to resign from his position two years before the end of his term. By January 6, the Argentine government, now under President Eduardo de Haldi and Economy Minister Jorge Remes Lenacov, conceded that it could no longer keep the inflated and overvalued peso pegged to the dollar at the rate of one to one. and it devalues the peso by 30% to a rate of 1.4 pesos per dollar. Even at this official rate of exchange, however, it appears that the peso is still overvalued because pesos were trading for dollars on the black market at far higher rates.

25:27The Argentine government recognized this and instead of permitting the exchange rate to depreciate to a realistic level reflecting the past inflation and current lack of confidence in the peso, It intensified the confiscatory deflation imposed on the economy earlier. It froze all savings accounts above $3,000 for a year. A measure that affected at least one-third of the $67 billion of deposits remaining in the banking system. $43.5 billion of these deposits are in dollars and the remainder in pesos. Depositors who hold dollar accounts not exceeding $5,000 will be able to withdraw their cash in 12-month monthly installments In the meantime, as one observer points out, Mr. Lenikov frankly admitted that this latest round of confiscatory deflation was a device for protecting the inherently bankrupt fractional reserve system, declaring, If the banks go bust, nobody gets their deposits back. The bunny on hand is not enough to pay back all depositors.

26:53Bankrupt Fraction Reserve System, declaring, quote, If the banks go bust, nobody gets their deposits back. The bunny on hand is not enough to pay back all depositors. So we have an August economy minister finally admitting this. Unlike the bank credit deflation that Lenikov is so eager to deflate, which would permit monetary exchange to proceed with a smaller number of more valuable pesos, Confiscatory deflation tends to abolish monetary exchange and propels the economy back to grossly inefficient and primitive conditions of barter and self-sufficient production that undermine the social division of labor. In the meantime, many of its unfortunate Argentine victims have recognized confiscatory deflation for what it essentially is, bank robbery by the political elites.

27:41Ramona Ruiz, a retired textile worker, railed at an empty ATM machine. That is my money inside that bank, mine. Another unidentified woman yelled at a government spokesman, how dare you take my savings. Jose Valenzuela, an Argentine salesman, stated, quote, it's as if while I am talking to you I am swiping the change from your pocket. Finally, and I knew there was one, there may be something good about unions, finally, Argentine union leaders denounced the policy as, quote, the hijacking of a nation's savings, unquote. So there you have it, good deflation and bad deflation. As Frank Schostock pointed out, the U.S. is not on the precipice of any sort of deflation. I would go on if I had time and talk a little bit more about the supply sliders and their ridiculous claims, but I'll stop here. Thank you.