Safe Haven | Bernanke and Obama's Advisors are Wrong: Deflation Did Not Threaten the US Economy

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January 18, 2009

Bernanke and Obama's Advisors are Wrong: Deflation Did Not Threaten the US Economy
by Gerard Jackson

I was going to explain in greater detail why Obama's economic stimulus would fail and why his view that only the government, meaning his administration, can get the economy moving is unadulterated nonsense. However, we are still being regaled with tales of how deflation is a dangerous threat, that the fall in asset prices needs to be reversed and that pumping unprecedented amounts of newly-created money into the economy is vital if recession is to be avoided -- and so on.

The striking thing about the warnings of impending deflation is that they never tell us what deflation is. If the public doesn't understand the nature of deflation then it will be misled into supporting monetary policies that are guaranteed to bring surging inflation in their wake followed by yet another recession. Without a doubt deflation is a greatly misunderstood phenomenon. The basic problem is that falling prices are not always a symptom of deflation. Moreover, the downward adjustment in prices between overvalued assets should not be confused with deflationary pressure.

Although falling prices can never be deflationary they can be a symptom of deflation. On the other hand, falling prices can be the favourable result of a productivity-induced change in purchasing power. This is precisely what we would expect in a progressing economy, i.e., one in which per capita investment is growing. It ought to go without saying that this investment embodies technological improvement that raise the productivity of capital and hence labour.

On the other hand, deflation occurs where the absolute quantity of money shrinks. This invariably happened when there was a run on the banks. When depositors withdrew their money a reverse multiplier set in and a rapid monetary contraction occurred bringing a recession in tow. The result was that prices had to fall if the number of transactions was not to fall. Of course, true deflations are always accompanied by depressions because what is contracting is not notes or coins, i.e., cash, but fictitious bank deposits, the product of credit expansion produced by a fractional reserve banking system. This is where we get our reverse multiplier.

Strictly speaking these monetary disturbance could not occur in an economy based on the gold standard. Even today the great majority of economists do not understand this fact. Alan Wood, an economics writer for The Australian, is one such economist. He argued against the gold standards on the specious grounds that its "costs in economic and social dislocation are too high." Sheer baloney. The problem was that Britain, like other gold standard countries, was actually operating on a quasi-gold standard.

Sir George Paish stated that before 1913 the Bank of England's gold reserves never exceeded $50,000,000. Jacob Viner was surprised to learn that the British banking system rested on an extremely low ratio of gold to liabilities. He estimated that sometimes the ratio "fell at times to as low as 2 per cent and never between 1850 and 1890 exceeded 4 per cent" (Jacob Viner Studies in the Theory of International Trade, Harper & Brothers, 1937, p. 264).

The problem was not gold but the fractional reserve banking system. I doubt that the low ratio of gold to paper and checking accounts would have posed much of a danger if it had been kept at a fixed ratio. In effect, this would have meant that the aggregate money supply would have been solely determined by changes in the quantity of gold. As the quantity of gold never fell this meant that the gold supply would have dictated the rate of monetary growth without any severe monetary disorders occurring. But credit creation by the banks made this impossible. And it was credit creation that caused the financial crises and still does. So we now find that the gold standard has been successfully blamed for the "costs in economic and social dislocation" that were in fact caused by deviations from the gold standard*.

It should be noted that though money incomes fall during a deflation real purchasing power rises. Attempts to prevent this adjustment process will prolong the recession. This is exactly what happened under Hoover and Roosevelt. From June 1936 onward America was forced to endure rising prices and mass unemployment. An unprecedented occurrence in US economic history and one that is now taken as normal.

But America in 2008 was not the America of 1930. There was never any danger of mass runs on the banks. The vast majority of Americans are of the opinion -- rightly in my view -- that the fed would not allow the banking system to collapse, an opinion that Bernanke's monetary policy has strongly reinforced. The danger is that by flooding the system with money Bernanke will trigger a wave of inflation. Considering his unwavering devotion to the Keynesian faith I think this is a highly likely outcome. To top it off, the crisis was the outcome of Keynesian policies that have given Obama the excuse to massively increase government spending. I think the results are going to be pretty ugly.

No doubt some of you have still have doubts about the benefits of productivity-induced falling prices, particularly when so many economic commentators -- including supply-siders -- argue that a stable price level is necessary if recessions are to be avoided. In support of this opinion some have drawn attention to the British experience in the last quarter of the nineteenth century that was labelled the "Great Depression".

In fact, during the nineteenth century Britain experienced more than 50 years of falling prices, even though living standards rose at an unprecedented rate. From 1875 to 1895 wholesale prices fell by about 45 per cent while industrial output and real wages continued to rise. Unfortunately some financial advisers took this to mean that deflation is not a real danger. Unfortunately for them they were not describing deflation.

Prices fell in nineteenth century Britain because productivity outstripped the gold supply. Because prices were flexible and price changes fairly slow wages and costs adjusted themselves easily to changing monetary conditions. This meant that as output grew faster than the gold supply prices not only fell but the benefits of increasing productivity were more evenly spread and living standards steadily rose as did money wages. The following chart shows the movement of prices in nineteenth century Britain.

Wholesale Prices in Britain, 1815-1913 (1900=100)

Source: S. B. Saul: The Myth of the Great Depression
1873-1896, 2nd edition,Macmillan Publishers LTD, 1985.

It should be noted that the gold standard also regulates to a considerable degree the supply of gold. The market responds to the increase in the value of gold created by falling prices by expanding the money supply. As the value of gold rises this encourages more gold prospecting and the means to extract gold from low-grade ores. Milton Friedman opposed the gold standard, believing that it was necessary to expand the money supply at a rate that would maintain a constant purchasing power by preventing prices from falling. Nevertheless, he was forced to admit that a productivity-induced falling price level had no detrimental effect on economic growth. (How could it when it was economic growth that produced it).

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867-1960, Princeton, N.J.: Princeton University Press, 1971, p. 15).

What the monetarists cannot see, anymore than the other neo-classical economists, is that price-level stabilisation policies must eventually create a boom-bust situation. In the 1920s qualitative economists like Benjamin M. Anderson, Ludwig von Mises and Frederich von Hayek, Felix Somary, etc., warned that the fed's price stabilisation policy had generated a boom and created imbalances that would have to liquidated once the recession struck. It was pointed out later on in the depression that the current

...difficulties are viewed largely as the inevitable aftermath of the world's greatest experiment with a "managed currency" within the gold standard, and, incidentally, should provide interesting material for consideration by those advocates of a managed currency which lacks the saving checks of a gold standard to bring to light excesses of zeal and errors of judgment. (C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 56).

Keynes strongly disagreed with these economists' analysis of the fed's monetary policy, stating:

The successful management of the dollar by the Federal Reserve board from 1923 to 1928 was a triumph -- mitigated, however, by the events of 1929-30 -- for the view that currency management is feasible, in conditions which are virtually independent of the movements of gold. (John Maynard Keynes A Treatise on Money , Vol. II, Macmillan and Co., Limited, 1953, p. 258).

It is now impossible to discuss Obama's 'economic policy' without referring to the Great Depression, and that is as it should be. Hence my all too brief tour of the 1930s. But if the lesson of the 1920s and the 1930s had been properly understood there would be no financial crisis today and no Obama. As he is clearly ignorant of these events, and the controversies they gave rise to, and has no apparent inclination to learn, I fear the US and the rest of the world is in for a very interesting four years.

*After the war there were three gold standards: the gold standard as it is commonly understood, the gold bullion standard and the gold exchange standard. Their differences were not trivial and had severe economic consequences and political repercussions. Unfortunately Australia's rightwing are as ignorant of these facts as they are of Austrian capital theory.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.