During the period 1920 to 1960, we can observe that the annual growth rate of production was more volatile than between the period 1961 to February 2019. During the first period the maximum growth rate stood at 62% and the minimum growth rate at minus 33.7%. Between 1961 to present, the maximum growth rate stood at 13.4% and the minimum growth rate at minus 15.3%, (see chart). One is tempted to conclude from this that this raises the likelihood that fiscal and monetary policies are currently more successful than in the past in stabilizing the economy.
For most economic experts the role of central authorities is to make the so-called economy as stable as possible. What do they mean by economic stability?
Economic stability refers to an absence of excessive fluctuations in the overall economy. An economy with constant output growth and low and stable price inflation is likely to be regarded as stable. An economy with frequent boom-bust cycles and variable price inflation would be considered as unstable.
According to popular thinking, stable economic environments in terms of stable price inflation and stable output growth acts as a buffer against various shocks. This makes it much easier for businesses to plan. In this way of thinking in particular, price level stability is the key for so-called economic stability.
For instance, let us say that a relative strengthening in people’s demand for potatoes versus tomatoes took place. This relative strengthening is going to be depicted by the relative increase in the prices of potatoes versus tomatoes.
Now to be successful, businesses must pay attention to consumers’ wishes as manifested by changes in the relative prices of goods and services. Failing to abide by consumers’ wishes will lead to the wrong production mix of goods and services and will lead to losses.
Hence, in our case, by paying attention to relative changes in prices, businesses are likely to increase the production of potatoes versus tomatoes.
On this way of thinking, if the price level is not stable then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
This leads to a misallocation of resources and to the weakening of economic fundamentals. Unstable changes in the price level obscure changes in the relative prices of goods and services. Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable.
Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability i.e. a stable price level.
The Contradiction Inherent in Fed Efforts to Stabilize Prices
By means of various quantitative methods, the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2%. Any significant deviation from this figure constitutes deviation from the growth path of price stability.
Observe that Fed policy makers are telling us that they have to stabilize the price level in order to allow the efficient functioning of the market economy.
Obviously, this is a contradiction in terms since any attempt to manipulate the so-called price level implies interference with markets and hence leads to false signals as conveyed by changes in relative prices.
By means of setting targets to interest rates and by means of monetary pumping it is not possible to strengthen economic fundamentals, but on the contrary, it only makes things much worse. Here is why.
Policy of Price Stability Leads to More Instability
Let us say that the so-called price level is starting to exhibit a visible decline in terms of growth momentum. To prevent this decline the Fed starts to aggressively push money into the banking system. Because of this policy the price level stabilizes after a time lag. Should we regard this as a successful monetary policy action? The answer is categorically no.
Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth generating activities obviously this leads to the weakening of the wealth generation process and to economic impoverishment.
Note that the economic impoverishment has taken place despite price level stability. Also, note that in order to achieve price stability the Fed had to allow an increase in the growth momentum of the money supply.
The fluctuations in the growth momentum of money supply is matter here. It is this, that set in motion the menace of the boom bust cycle regardless of whether the price level is stable or not.
While increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. If the real factors are pulling things in an opposite direction to monetary factors, then it is possible that no visible change in prices might take place.
In other words, while money growth is buoyant prices might display moderate increases.
Clearly, if we were to pay attention to the so-called price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.
On this, Rothbard wrote, in America’s Great Depression:
The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.
Money Neutrality Assumption Is at the Root of Price Stabilization Policies
At the root of price stabilization policies is the view that money is neutral. Changes in money only have an effect on the price level while having no effect whatsoever on the real economy. In this way of thinking changes in the relative prices of goods and services are established without the aid of money. For instance, if one apple exchanges for two potatoes then the price of an apple is two potatoes, or the price of one potato is half an apple. Now, if one apple exchanges for one dollar then it follows that the price of a potato is $0.5. Note that the introduction of money does not alter the fact that the relative price of potatoes versus apples is 2:1 (two-to-one). Thus, a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.
In this way of thinking, an increase in the quantity of money leads to a proportionate fall in its purchasing power i.e. a rise in the price level. While a fall in the quantity of money results in a proportionate increase in the purchasing power of money i.e. a fall in the price level. All that, according to this way of thinking, does not alter the fact that one apple is exchanged for two potatoes, all other things being equal.
Let us assume that the amount of money has doubled and as a result, the purchasing power of money has halved, or the price level has doubled. This means that now one apple can be exchanged for $2 while one potato for $1. Note that despite the doubling in prices a seller of an apple with the obtained $2 can still purchase two potatoes.
We have here a total separation between changes in the relative prices of goods (how many apples exchanged per potatoes) and the changes in the price level. Therefore, it would appear that the only problem with inflation is that it obscures the visibility in the movements of the relative prices of goods thereby causing a misallocation of resources. Other than that, inflation is harmless. Why this way of thinking is problematic?
When new money is injected there are always first recipients who benefit from this injection. With more money at their disposal, the first recipients can now acquire a greater amount of goods while the prices of these goods are still unchanged. As money starts to move around the prices of goods begin to rise. Consequently, the late receivers benefit to a lesser extent from the initial monetary injections or may even find that most prices have risen so much that they can now afford fewer goods.
Increases in money supply lead to a redistribution of real wealth from later recipients, or non-recipients of money to the earlier recipients. Obviously, this shift in real wealth alters individuals’ demands for goods and services and in turn alters the relative prices of goods and services. Changes in money supply sets in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as relative prices of goods are concerned.
The Price Level Cannot Be Ascertained Conceptually
The whole idea of the general purchasing power of money and hence the price level cannot, be even established conceptually.
When $1 is exchanged for one loaf of bread, we can say that the purchasing power of $1 is one loaf of bread. If $1 is exchanged for two tomatoes then this also means that the purchasing power of $1 is two tomatoes. The information regarding the specific purchasing power of money does not however allow the establishment of the total purchasing power of money. It is not possible to ascertain the total purchasing power of money because we cannot add up 2 tomatoes to 1 loaf of bread. We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place.
On this Rothbard wrote,
Since the general exchange-value, or PPM (purchasing power of money), of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.1
Now, the Fed’s monetary policy, which aims at stabilizing the price level, by implication, affects the growth rate of money supply. Since changes in money supply are not neutral, this means that central bank policy amounts to tampering with relative prices, which leads to the disruption of the efficient allocation of resources. As a result, a policy of stabilizing prices leads to over-production of some goods and under-production of some other goods. This is, however, not what the stabilizers are telling us. For they believe that the greatest merit of stabilizing changes in the price level is that it allows free and transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.
Economic Stability Has Nothing to do With Stabilizing the Economy
True economic stability is not about keeping price fluctuations stable but rather keeping price fluctuations free from interference. Only in an environment free of government and central bank’s tampering with the economy can free fluctuations in relative prices take place. This in turn is going to allow businesses to abide by the wishes of consumers (i.e. will permit an efficient allocation of scarce resources). Fluctuations in prices are going to mirror changes in the relative supply-demand conditions.
For most economists, the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability. However, by means of monetary policies, the Fed’s objective of stabilizing the price level actually undermines economic fundamentals. The fact that the annual growth rate of US industrial production was less volatile during 1961 to 2019 versus 1920 to 1960 is not something to be proud about. It reflects relatively more suppressed side effects of the central bank and the government tampering with the economy.
It would appear that the ever-growing interference of government and the central bank with the working of the markets is moving the US economy towards the growth path of persistent economic impoverishment and drastically lower living standards as time goes by.
- 1Murray N. Rothbard, Man, Economy, and State, Nash Publishing p 743
