Additional reading: Articles about the Great Depression.

Today’s document is a negative review of Henry Hazlitt’s book The Inflation Crisis and How to Resolve It by Marilyn Vencel, published in the Wilton Bulletin in September 1978, and two letters to the editor in response, one from Hazlitt’s friends Richard and Viola Turner and another from Hazlitt himself. Vencel’s review is mostly vicious and empty rhetoric, as the Turners point out, but at its heart is the complaint that Hazlitt’s theory on inflation is simplistic. Ironically, in making this argument she oversimplifies Hazlitt’s arguments to the point of distorting his position.

Now it stands to reason that a complex theory isn’t correct merely because it is complex. And similarly, a simple theory isn’t necessarily wrong because it is simple. After all, there is danger in overcomplicating matters. As Occam’s razor states, “Entities should not be multiplied unnecessarily.”

But there is another problem. Hazlitt’s argument against inflation uses basic economic theory, which is not really simple. Basic economic theory describes a complex order of economic forces at work, matching the most willing suppliers and the most willing demanders in order to realize mutual gains from exchange. It shows us markets work extremely well but only in the correct institutional context. Leonard Read’s “I, Pencil” tells us exactly why this is far from simple. And Hazlitt’s work on inflation tells us exactly why inflation distorts market signals.

Hazlitt’s book was of course put in simple terms. After all it was written for a popular audience, and the solution of “stop printing more money” is simple, but it is not a description of a simple theory. Inflation’s distortion of market signals is real and has negative consequences. Hazlitt’s book shows us why those consequences, such as the undermining of production incentives, are not something to brush aside. Institutions matter, and the rules regarding money are particularly important. Sound money is crucial for market forces to function properly. When one understands basic economic theory, one intuitively sees why inflation is undesirable, but that doesn’t mean the theory is simplistic.

Download the Wilton Bulletin review of Hazlitt’s The Inflation Crisis and How to Resolve It here.

Friedman, as with the other papers that day, found inflation to be a massive problem. In fact, next to the threat of a third world war, inflation is what he finds to be the most serious threat to the preservation of a free society. Friedman believed the source of inflationary pressure mainly stemmed from calls for governmental responsibility and action to correct deviations from full employment. Keynesian policy subscriptions clearly had become ingrained in the public and political consciousness as solutions to any economic downturn.

While the economics profession today has seemingly deviated away from such notions, the same cannot be said about the public in general. In my paper (co-authored with Daniel J. Smith and Peter Boettke), Been There, Done That: The Political Economy of Déjà Vu (which Dan Smith and I will be presenting at the Atlas Economic Research Foundation Tuesday, March 1^st), we argue the Keynesian debates of the 1930s, relating to government responses to a financial crisis, sound eerily similar to today’s debates on the current crisis.

Despite the advances in the economic tools developed in the last century, most Keynesian economists and policy “experts” revert back to the basic (and proven wrong) Keynesian solutions at the first sight of a downturn and the public eats it up. In the short run, these policies can indeed look very appealing. Politicians are seen to be doing something and, in doing so, temporarily remove the hurt caused by the crisis. But such actions lead us down, what Adam Smith called, a path of deficits, debt, and debasement of the currency. The solutions to the deficit must be to tax, borrow, or print more money. Raising taxes is often met with much resistance, so the government borrows but this is only a future tax. Printing money thus ends up as a real solution, as it is a hidden tax, which the public barely notices. But it is no less a serious problem in the long run, as Friedman points out.

This juggling trick of deficits, debt, and debasement is as much as threat today as it was in 1958. Friedman correctly points out what really needs to be done:

“The Major requisite for preventing these results is indeed “restraint” but not restraint on the part of business or labor with respect to individual price or wage changes. What we need is “restraint” on the part of the public at large in demanding vigorous governmental action the first sign of a downturn and on the part of governmental authorities in yielding to such demands. The crucial problem is how to get such “restraint.”

Economists, such as Friedman, have effectively pointed out the flaws of the Keynesian arguments. We are right to chide those who make Keynesian arguments for not learning what should be obvious, but free market economists have also been guilty of a lack of creative thinking of how to refute these arguments once and forever. As a result Keynesian ideas continue to pop up every time a crisis occurs. If we are to convince the public we cannot keep saying the same things over and over again.  As James Buchanan has said, “it takes varied reiterations to force alien concepts upon reluctant minds.”

Download Milton Friedman’s Mont Pelerin Essay, Inflation, here.

Historically governments inflated their currencies because they benefited in various ways. For example, they spent the new money, gaining the purchasing power lost by holders of the depreciating currency. This gain, called seigniorage, is an implicit tax on the people’s cash balances.

Another way government can gain is in its role as a debtor. If inflation is unanticipated, interest rates will not have risen enough to compensate lenders for the decline in purchasing power. Net debtors gain, and net creditors lose. Government, of course, is the economy’s biggest debtor. During the Great Inflation of the 1970s private investors holding long-term U.S. Treasury securities actually earned negative real returns despite receiving positive nominal interest. So from 1946 to 1982, while the government’s nominal debt to the general public rose from $242 billion to $925 billion, in 1946 dollars it had actually fallen to $201 billion.

If in the past inflations were able to ease the government’s financial problems, this is less true now since globalization gives investors more options.

Globalization, with the corresponding relaxation of exchange controls in all major countries, allows them easily to flee to foreign currencies, with the result that changes in central-bank policy are almost immediately priced by exchange rates and interest rates. Add to this the ability to purchase inflation-indexed government securities, and it becomes highly unlikely investors will be caught off guard by anything less than sudden, catastrophic hyperinflation (defined as more than 50% per month)–and maybe even not then.

Thus it would take a mighty and unexpected inflation indeed for the U.S. government to benefit in its current fiscal predicament–but at what cost?

The full commentary in Forbes here.

Hummel’s original Freeman article on government’s diminishing benefits from inflation is here.

This clearly seems like a complicated issue but in many ways its actually quite simple. F.A. “Baldy” Harper, an economist from Cornell University who worked for FEE in its first years and then founded the Institute for Humane Studies, wrote this 1951 pamphlet on inflation. For him, “inflation can be prevented. Failure to do so is purely and simply a matter of negligence.” And the way to prevent it is clear, “Inflation means too much money. The way to prevent inflation, then, is to close down the money factory. It is that simple.”

The issue is not how much money the government should print but is an institutional one. Economists define institutions as rules that constrain human behavior. Our current monetary system fails to constrain the government from the over printing of money. Currently the government has a monopoly over the monetary system; as Harper points out, if you don’t believe this just try and make your own money. The government wishes to hold this monopoly in order to cover what it spends in excess of its income, i.e. tax revenue. In essence, inflation is simply a hidden tax on every dollar we hold. The government thus has the incentive to print as much money that will maximize its revenue. It is similar to the government basically having an incentive to consistently water down a bowl of punch.

A monopoly in money essentially boils down to a planned monetary system. As Carl Menger, the founder of the Austrian school of economics, showed money did not emerge from the state but through a spontaneous order brought about by the complex interaction of many individuals. In the past, money, usually gold, was produced through a competitive process. Anyone could produce it. By allowing our monetary system to instead be “planned” by the government we have created what economist Gordon Tullock called a social dilemma. Society would be better off if the government did not inflate the money supply but the government gains from doing it, thus, just like a prisoner’s dilemma, we end up with a non-socially optimal outcome.

Maybe the situation is not as simple as Harper suggests. It is after all no simple task to remove the government monopoly on money. But as Harper points out, we are left with only two options, “the only escape from the consequences of these laws would seem to be for the citizens to ignore them. This means lawlessness, technically, in the form of black market operations and all the other forms of evasion. This places the honest citizen who favors human liberty in a strange dilemma. He must choose between practicing lawlessness in the technical sense, or supporting a socialist-communist regime.” What is simple is that the government has forced planning in our monetary system upon us. This makes Harper’s pamphlet extremely relevant even today.

Download F.A. “Baldy” Harper’s pamphlet on Inflation here.

Over the past few months the Distress Index had fallen slightly from an alarming 61.7 in June, which marked the highest economic distress in over 30 years. Many had hoped this would lead to a full economic turnaround. But rising unemployment and the return of consumer price inflation dashed those hopes and confirmed the economy is still in deep distress.

“The minor excitement about turning the corner and coming into a recovery may have been premature. Even the President is now warning of a double-dip recession,” said Prof. Paul Cwik, co-creator of the index. Cwik, an associate professor of economics at Mt. Olive College in North Carolina, warned that the “current recession is far from over” and noted that the trillions of dollars that have been pumped into the economy are now “starting to have an effect on some prices, which will only hinder the necessary liquidation process.”

To learn more about the Distress Index, visit (http://fee.org/distress-index/) or contact Mike Van Winkle at (708) 289-3136 or mvanwinkle@fee.org.

</p> <p>It does not appear your browser supports iframes.</p> <p>

Articles

• Toward Radical Monetary Reform by Lawrence W. Reed
• Gold versus Fractional Reserves by Henry Hazlitt
• Central Banks, Gold, and the Decline of the Dollar by Robert Batemarco
• How Gold Was Money- How Gold Could be Money Again by Richard H. Timberlake
• Gold Standard by Ludwig von Mises
• The Gold Standard and Fractional Reserve Banking by Joe Cobb
• Back to Gold? by Henry Hazlitt
• Money and Gold in the 1920s and 1930s by Joseph T. Salerno
• No Shortage of Gold by Hans F. Sennholz
• How to Return to Gold by Henry Hazlitt
• The Solution by Murray N. Rothbard
• A Golden Comeback, Part 1 by Mark Skousen
• A Golden Comeback, Part 2 by Mark Skousen
• A Golden Comeback, Part 3 by Mark Skousen
• The Value of Money by Hans F. Sennholz
• A Closer Look at Gold by Charles E. Weber
• Hazlitt on Gold by Jude Blanchette
• How Much Money? by Percy L. Greaves Jr.
• The Future of the Dollar by Henry Hazlitt
• Gold Policy in the 1930s by Richard H. Timberlake

Audio

• Peace and Gold by Steve Horwitz
• Is the Gold Standard a Viable Policy Option? by Lawrence White

The mercantilists of the 1600s raised this error to the pinnacle of national policy. Always bent upon heaping up hoards of gold and silver, they made war on their neighbors and looted their treasures. If England was richer than France, it was, according to the mercantilists, because England had more precious metals in its possession, which usually meant in the king’s coffers.

It was Adam Smith, in The Wealth of Nations, who exploded this silly notion. A people are prosperous to the extent they possess goods and services, not money, Smith declared. All the money in the world—paper or metallic—will still leave one starving if goods and services are not available.

The “money is wealth” error is the affliction of the currency crank. From John Law to John Maynard Keynes, great populations have hyperinflated themselves to ruin in pursuit of this illusion. Even today we hear cries of “we need more money” as the government’s monetary authorities crank it out at double digit rates.

The good economist will recognize that money creation is no short-cut to wealth. Only the production of valued goods and services in a market which reflects the consumer’s wishes can relieve poverty and promote prosperity.

Those words are still true, if only because our political and financial “leaders” want us to believe that they can end the current recession if the Federal Reserve System creates “liquidity.”  Thus, we see the Fed doing whatever it can to push more money into the economy.

One reason that the “money is wealth” fallacy has thrived for so long is that many people – including academic economists – fall prey to another fallacy, the fallacy of composition (discussed last week).  In the case of money, it is especially pernicious.

Assume, for example, that I had a printing press in my house which could crank out undetectable counterfeit money.  I could print huge amounts and purchase whatever I pleased.  No doubt, I would be better off (as long as the authorities did not discover what I was doing), but others would be made worse off.

First, and most important, is the nature of money.  Money is a good that is used to trade for other goods, and by making trade easier (and more abundant), it is a productive asset.

However, as Adam Smith understood, money itself is not wealth; instead, it is a good that we use in order to obtain wealth.  (Pieces of government-produced green paper do not qualify as historical “money.”  Government’s monopoly on money has led to its debasement.)

Second, money follows the same economic laws that govern all other goods.  The more money created, the less its marginal value.  (In other words, money is subject to the Law of Decreasing Marginal Utility.)  Many economists have missed this point.

In typical academic classes, money is described as a quantity variable.  Double the amount of money and the “price level” doubles as well, but the monetary increase has brought about no real harm.  Other academic models note that an increase in the amount of money will increase the amount of wealth (call it “Gross Domestic Product”), even if it also raises the “price levels.”

While such models are easy to teach (and to use for solving math problems), nonetheless they are inaccurate at best and dangerous at worst.  They do not demonstrate what really happens when the amount of money in an economy is increased.  If the process of creating more and more money by fiat (called inflation) goes on unchecked, as it did during the past decade, then not only does the value of money on the margin fall, but its growth triggers an unsustainable boom that ultimately collapses in a bust.

This process has repeated itself time and again, which demonstrates that most policy makers do not understand that money is not wealth.  The lesson still has not been learned.

Next Week: The Fallacy of Production for its Own Sake

The Federal Reserve has been pumping hundreds of billions of newly created dollars into “the economy.” Much of that money has been sent to Wall Street to bailout large, struggling firms. But that’s just the beginning. President-elect Obama says that since he needs to “stimulate the economy” we can look forward to trillion-dollar budget deficits for years to come. Even before the financial turmoil began, the deficit had approached $500 billion. (Not to worry, though–Obama says deficit spending will impose “fiscal discipline” in the future.)

Of course, when the federal government spends more than it taxes, it has to get the extra money somewhere. Therein lies the treachery. The government’s vendors and other beneficiaries demand to be paid on time. So it borrows from the credit markets by selling Treasury securities to investors. The Federal Reserve in turn monetizes the debt by buying Treasury securities in the marketplace. It pays for those securities by creating bank reserves–money–from nothing, or as John Maynard Keynes suggested, by performing the “miracle … of turning stone into bread.”

Since we, like the rest of the world, have long lived with a fiat-money system–that is, a system in which the paper money is not backed by anything–there is nothing remarkable about this for most people (if they are aware of the procedure at all). But before long, they will pay a steep price whether or not they know who the culprit is.

The central bank’s expansion of money and credit used to be called inflation. Today that word is used mostly for one of the consequences of monetary expansion: generally rising prices. That’s unfortunate because that definition papers over the most important effects of deficit spending and monetary inflation.

To think of inflation as generally rising prices is to miss the real point. If an increase in the money simply raised the “price level” uniformly, it would be little more than an inconvenience. Prices might outrun wages at first, reducing real incomes, but soon wages would catch up and, in real terms, we’d be back where we started. The dollar values would larger, but without real consequence.

That’s not how  it works, though. Ludwig von Mises explained the process in a lecture he gave in Paris in 1938 and again in New York in 1945. It was later published under the title “The Non-Neutrality of Money.” (It appears in Money, Method, and the Market Process: Essays by Ludwig von Mises, edited by Richard M. Ebeling.)

Barter Economy

In this lecture Mises was determined to disabuse his listeners of their belief in the neutrality of money–that is, the idea that changes in the money supply leave real factors undisturbed. He understood why economists have held this erroneous belief. They began thinking of exchange in the admittedly simplified terms of a barter economy in which goods exchange for other goods. When they added money to this unrealistic picture, they assumed nothing of importance changed. As Mises put it, they believed “The functioning of the market mechanism as demonstrated by the concept of pure barter was not affected by monetary factors.”

These economists acknowledged that money prices can vary, but “they believed–and this is exactly the essence of the fallacy of money’s neutrality–that these changes in purchasing power were brought about simultaneously in the whole market and that they affected all commodities to the same extent.” Thus according to this view, the price level changes, but relative prices do not.

Here’s the problem. There really is no price level, except for ones constructed by averaging the prices of an arbitrary basket of goods and services. What really exist–and therefore what really count–are millions of prices for goods and services that are constantly subject to change in relation to one another. These prices emerge from the decisions of potential buyers and sellers who pursue their ends according to their subjective priorities.

You’d hardly know this by reading mainstream economics, but economic phenomena happen on the ground–where human action and interaction take place–and not at the level of statistical aggregates and averages that no real person ever encounters..

“Monetary problems are economic problems and have to be dealt with in the same way as all other economic problems,” Mises continued. He meant that when analyzing inflation and other monetary issues, our focus should not be “the economy” holistically conceived. As he put it, “Changes in the quantity of money and in the demand for money for cash holding do not occur in the economic system as a whole if they do not occur in the households of individuals. These changes in the households of individuals never occur for all individuals at the same time and to the same degree and they therefore never affect their judgments of value to the same extent and at the same time.”

In the economists’ lingo, macroeconomics is, or should be, rooted in microeconomics.

Inflation and Its Consequences

Take inflation. When the government expands the supply of money, it does not do so by dropping Federal Reserve notes evenly across the land from the proverbial helicopter. In the old days government would print money or filch precious metals to make coins, then spend the money as it liked. A few select people received the money first, and they could then enter the market and buy what they liked at prices still unaffected by the inflation. the late receivers were the losers.

These days the process is more complicated. The Treasury borrows money from private lenders by selling securities. With that cash it pays contractors and welfare-state beneficiaries. Meanwhile, the Federal Reserve creates money in the form of bank reserves by buying government securities. It’s called monetizing the debt. Banks then pyramid loans on these new reserves, expanding the money supply and lowering interest rates. Among the consequences is the depreciation of the monetary unit (rising prices) and the boom-bust trade cycle described by Mises and F.A. Hayek. (Hayek won his Nobel Prize in 1974 partly for his work on the trade cycle.).

Whichever method is used, the point is that the newly created money enters the economy at specific points rather than blanketing society evenly. The result is a diversion of the economy from the path it would have taken in the absence of the disturbance. A new pattern emerges the details of which cannot be predicted. Why not? Because people are people not robots. If your cash balance doubled tomorrow you wouldn’t mechanically double the quantities of everything you buy now . Instead, you would change the proportions–buy more of this and less of that–and even buy things you don’t buy today. You yourself can’t predict exactly what you would do in these circumstances.

“The additional quantity of money does not find its way at first into the pockets of all individuals; not every individual of those benefited first gets the same amount and not every individual reacts to the same additional quantity in the same way…,” Mises summed up. “The additional amount of money offered by them on the market makes prices and wages go up. But not all the prices and wages rise, and those which do rise do not rise to the same degree.”

Income Distribution

Now things get interesting. We begin to see that inflation is a form of government distribution of income. (I don’t say “redistribution” because in a true market economy income is not distributed but rather acquired through exchange.)

“If [for instance] the additional money is spent for military purposes,” Mises wrote, “the prices of some commodities only and the wages of only some kinds of labor rise, others remain unchanged or may even temporarily fall. They may fall because there are now on the market some groups of men whose incomes have not risen but who nevertheless are obliged to pay more for some commodities, namely for those asked by the men first benefited by the inflation. Thus, price changes which are the result of the inflation start with some commodities and services only, and are diffused more or less slowly from one group to the others. It takes time till the additional quantity of money has exhausted all its price changing possibilities.”

Make no mistake about it. This is a government-engineered transfer of resources, that is, a violation of property rights. And by the way, the distribution is not from rich to poor. If anything, the distribution is upwards.

As Mises explained, “But even in the end the different commodities are not affected to the same extent. The process of progressive depreciation has changed the income and the wealth of the different social groups. As long as this depreciation is still going on, as long as the additional quantity of money has not yet exhausted all its possibilities of influencing prices, as long as there are still prices left unchanged at all or not yet changed to the extent that they will be, there are in the community some groups favored and some at a disadvantage…. As long as the inflation is in progress, there is a perpetual shift in income and wealth from some social group, to other social groups.”

We have seen that government expansion of the money supply rearranges resources in society and interferes with the market’s natural tendency to serve consumers according to their own priorities. Thus inflation would be objectionable even if it did not cause malinvestment and seed the ground for a subsequent depression, that is, even if it did not spawn the trade cycle.

It is incumbent on the inflationists–specifically, the incoming government officials–to explain why income distribution is a proper function of government.