Everybody knows that Lord Keynes favored an inflationary monetary policy. He thought that expanding the money was a way that the business cycle could be bypassed, by making booms perpetual. Of course, Austrian business cycle theory teaches us that this policy won’t work and, if continued, will result in hyperinflation, destroying the use of money completely. Keynes also had an inflationist view of history, according to which the general trend of prices tends to be upward in the long run. He thought this would lead to progress, for reasons different from his business cycle theory. Ludwig von Mises criticized Keynes’s arguments for this view, and I’d like to discuss these arguments in this week’s column.
Mises summarizes the inflationist interpretation of history in this way:
A very popular doctrine maintains that progressive lowering of the monetary unit’s purchasing power played a decisive role in historical evolution. It is asserted that mankind would not have reached its present state of well-being if the supply of money had not increased to a greater extent than the demand for money. The resulting fall in purchasing power, it is said, was a necessary condition of economic progress. The intensification of the division of labor and the continuous growth of capital accumulation, which have centupled the productivity of labor, could ensue only in a world of progressive price rises. Inflation creates prosperity and wealth; deflation distress and economic decay. A survey of political literature and of the ideas that guided for centuries the monetary and credit policies of the nations reveals that this opinion is almost generally accepted. In spite of all warnings on the part of economists it is still today the core of the layman’s economic philosophy. It is no less the essence of the teachings of Lord Keynes and his disciples in both hemispheres.
In other words, Mises is saying that according to this theory, economic progress depends on making the division of labor more intense, and this process will continue only if people expect the purchasing power of money to go up (i.e., for prices to fall).
Mises acknowledges that the trend of prices has been upward, although this can’t be established with “catallactic precision”:
It is obvious that the problems raised by the inflationist doctrine cannot be solved by a recourse to the teachings of historical experience. It is beyond doubt that the history of prices shows, by and large, a continuous, although sometimes for short periods interrupted, upward trend. It is of course impossible to establish this fact otherwise than by historical understanding. Catallactic precision cannot be applied to historical problems. The endeavors of some historians and statisticians to trace back the changes in the purchasing power of the precious metals for centuries, and to measure them, are futile. It has been shown already that all attempts to measure economic magnitudes are based on entirely fallacious assumptions and display ignorance of the fundamental principles both of economics and of history. But what history by means of its specific methods can tell us in this field is enough to justify the assertion that the purchasing power of money has for centuries shown a tendency to fall. With regard to this point all people agree.
Mises deploys two arguments against the claim that businessmen won’t expand production unless they anticipate that prices won’t fall. The first argument is that if the government didn’t keep expanding the supply of money, an increase in productivity would lead to a rise in the purchasing power of money (i.e., a fall in prices). Businessmen would adjust to this and would expect prices to fall. If they did so, the fact that prices weren’t rising wouldn’t lead them to stop investing. As Mises says:
Living and acting in an environment in which a slow but continuous fall in the monetary unit’s purchasing power is deemed normal, necessary, and beneficial, he [the average businessman] simply cannot comprehend a different state of affairs. He associates the notions of rising prices and profits on the one hand and of falling prices and losses on the other. The fact that there are bear operations too and that great fortunes have been made by bears does not shake his dogmatism. These are, he says, merely speculative transactions of people eager to profit from the fall in the prices of goods already produced and available. Creative innovations, new investments, and the application of improved technological methods require the inducement brought about by the expectation of price rises. Economic progress is possible only in a world of rising prices. This opinion is untenable. In a world of a rising purchasing power of the monetary unit everybody’s mode of thinking would have adjusted itself to this state of affairs, just as in our actual world it has adjusted itself to a falling purchasing power of the monetary unit. Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement of his material well-being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible.
But, and this is Mises’s second argument, businessmen aren’t interested in the long-term trend of prices, whether up or down. What they care about is whether they can spot differences in price spreads in particular markets that will allow them to make a profit. As Mises puts it:
In the conduct of business, reflections concerning the secular trend of prices do not bother any role whatever. Entrepreneurs and investors do not bother about secular trends. What guides their actions is their opinion about the movement of prices in the coming weeks, months, or at most years. They do not heed the general movement of all prices. What matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the products. No businessman embarks upon a definite production project because he believes that the prices, i.e., the prices of all goods and services, will rise. He engages himself if he believes that he can profit from a difference between the prices of goods of various orders. In a world with a secular tendency toward falling prices, such opportunities for earning profit will appear in the same way in which they appear in a world with a secular trend toward rising prices.
Mises makes clear that he is not advocating a policy of government-induced deflation. As always, it is best to let the free market operate unhindered. Laissez-faire!
