And what is one half of almost every exchange? Money. Based solely on this fact, it is easy to see the importance money play in any economy. Without money how could an exchange take place? Well, barter is an option but this sort of a direct exchange is extremely difficult.

If we produced everything ourselves, and did not exchange, then life would be more than tough. Many of the luxuries we enjoy would simply not be possible. In order to achieve the advanced material production, we have become accustomed that we need to engage in specialization and the division of labor. But under the division of labor, barter requires the double coincidence of wants. One must hope that the person who produces what they want will also want what they produce. Due to this problem, as Carl Menger explained, money, or a medium of exchange emerged. Now one accepts money not as an end in itself, but as a means of acquiring what one truly wants. You accept money because you know others will similarly accept it.

What this really tells us is that money was not created by the state. No central authority was needed to create it. It was an emergent spontaneous order; a result of human action, but not of human design. But something funny happened along the way. Trust in the ability of the market to provide money seems to have disappeared. The common view now seems to be that the state needs to hold the monopoly on the production of our currency.

Yet, we constantly face troubles with our monetary system. Many economists have attempted to solve these problems but even then kept the power solely in the hands of the state. Even Milton Friedman, for example, believed in favoring rules over discretion within the government monopoly over money. So, free trade is good, but only if a central authority can create and maintain our currency?

F.A. Hayek in the late 70s, “suggested a radical cure, – i.e., taking away the government monopoly of issuing money, and handing the task to private industry –partly as a bitter joke.” Hayek’s position on money shifted throughout his career but by 1975, the more he thought about it, his position went from a ‘bitter joke’ to completely supporting privatization of the money supply, as he explains in this 1977 Wall Street Journal article.

It is hard to see what is so “funny” about private money. After all, money was originally created and provided this way. Even in our more complex modern financial systems, private banks, not the state, originally provided bank notes, which are technically what our Federal Reserve notes are. And this system of free banking worked extremely well, as economist Lawrence White pointed out.

The state has a lot to gain through the monopoly profits earned with its control over money supply, but on the flip side we, as individuals, have a lot to lose. Maybe the real joke is with our current system, which is sad because the joke is on us.

Download The 1977 Wall Street Journal article Toward Free Market Money by F.A. Hayek here.

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.

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.