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The Great Recession (or the Great Hangover) that began in 2008 did not have to happen. Its causes and consequences are not mysterious. Indeed, this particular and very painful episode affirms what the best nonpartisan economists have tried to tell our politicians and policy-makers for decades, namely, that the more they try to inflate and direct the economy, the more damage the rest of us will suffer sooner or later. Hindsight is always 20-20, but in this instance, good old-fashioned common sense would have provided all the foresight needed to avoid the mess we’re in.

In this essay, we trace the path of the recession from its origins in the housing market bubble to the policies offered to cure the aftermath.

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.

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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.