The Free Market 4, no. 9 (September 1986)
In the last few months, the Reagan administration seems to have achieved the culmination of its “economic miracle” of the last several years: while the money supply has skyrocketed upward in double digits, the consumer price index has remained virtually flat. Money cheap and abundant, stock and bond markets booming, and yet prices remaining stable: what could be better than that? Has the President, by inducing Americans to feel good and stand tall, really managed to repeal economic law? Has soft soap been able to erase the need for “root-canal” economics?
In the first place, we have heard that song before. During every boom period, statesmen, economists, and financial writers manage to find reasons for proclaiming that now, this time, we are living in a new age where old-fashioned economic law has been nullified and cast into the dust bin of history. The 1920s is a particularly instructive decade, because then we had expanding money and credit, and a stock and bond market boom, while prices remained constant. As a result, all the experts as well as the politicians announced that we were living in a brand “new era,” in which new tools available to government had eliminated inflations and depressions.
What were these marvelous new tools? As Bernard M. Baruch explained in an optimistic interview in the spring of 1929, they were (a) expanded cooperation between government and business; and (b) the Federal Reserve Act, “which gave us coordinated control of our financial resources and ... a unified banking system.” And, as a result, the country was brimming with “self-confidence.” But, also as a result of these tools, there came 1929 and the Great Depression. Unfortunately both of these mechanisms are with us today in aggravated form. And great self confidence, which persisted in the market and among the public into 1931, didn’t help one whit when the fundamental realities took over.
But the problem is not simply history. There are very good reasons why monetary inflation cannot bring endless prosperity. In the first place, even if there were no price inflation, monetary inflation is a bad proposition. For monetary inflation is counterfeiting, plain and simple. As in counterfeiting, the creation of new money simply diverts resources from producers, who have gotten their money honestly, to the early recipients of the new money—to the counterfeiters, and to those on whom they spend their money.
Counterfeiting is a method of taxation and redistribution—from producers to counterfeiters and to those early in the chain when counterfeiters spend their money and the money gets respent. Even if prices do not increase, this does not alleviate the coercive shift in income and wealth that takes place. As a matter of fact, some economists have interpreted price inflation as a desperate method by which the public, suffering from monetary inflation, tries to recoup its command of economic resources by raising prices at least as fast, if not faster, than the government prints new money.
Secondly, if new money is created via bank loans to business, as much of it is, the money inevitably distorts the pattern of productive investments. The fundamental insight of the “Austrian,” or Misesian, theory of the business cycle is that monetary inflation via loans to business causes over-investment in capital goods, especially in such areas as construction, long-term investments, machine tools, and industrial commodities. On the other hand, there is a relative underinvestment in consumer goods industries. And since stock prices and real estate prices are titles to capital goods, there tends as well to be an excessive boom. It is not necessary for consumer prices to go up, and therefore to register as price inflation. And this is precisely what happened in the 1920s, fooling economists and financiers unfamiliar with Austrian analysis, and lulling them into the belief that no great crash or recession would be possible. The rest is history. So, the fact that prices have remained stable recently does not mean that we will not reap the whirlwind of recession and crash.
But why didn’t prices rise in the 1920s? Because the enormous increase in productivity and the supply of goods offset the increase of money. This offset did not, however, prevent a crash from developing, even though it did avert price inflation. Our good fortune, unfortunately, is not due to increased productivity. Productivity growth has been minimal since the 1970s, and real income and the standard of living have barely increased since that time.
The offsets to price inflation in the 1980s have been very different. At first, during the Reagan administration, a severe depression developed in 1981 and continued into 1983, of course dragging down the price inflation rate. Recovery was slow at first, and in the last few years, three special factors have held down price inflation. An enormous balance of trade deficit of $150 billion was eagerly financed by foreign investors in American dollars, which kept the dollar unprecedentedly high, and therefore import prices low, despite the huge deficit.
Secondly, and unusually, a flood of cash dollars stayed overseas, in hyperinflating countries of Asia and Latin America, to serve as underground money in place of the increasingly worthless domestic currency. And thirdly, the well-known collapse of the OPEC cartel at last brought down oil and petroleum product prices to free-market levels. But all of these offsets are obviously one-shot, and are rapidly coming to an end. In fact, the dollar has already declined in value, compared to foreign currencies, by about 30 percent since last September.
We are left with the fourth offset to price inflation, the increased willingness by the public to hold money rather than spend it, as the public has become convinced that the Reagan administration has discovered the secrets to an economic miracle in which prices will never rise again. But the public has not been deeply convinced of this, because real interest rates (interest rates in money terms minus the inflation rate) are at the highest level in its history. And interest rates are strongly affected by people’s expectations of future price inflation; the higher the expectation, the higher the interest rate.
We may therefore expect a resumption of price inflation before long, and, as the public begins to wake up to the humbug nature of the “economic miracle,” we may expect that inflation to accelerate.
