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June 16, 2003

I Dinna Ken Aboot Tha'
by Sean Corrigan

The IMF's latest brainwave has been to set up a deflation 'taskforce' under its chief economist Ken Roggoff. As you would expect, with that pedigree, its first report is a treasure trove of faulty logic, half-remembered folk myth and plain misrepresentation.

(http://www.imf.org/external/pubs/ft/def/2003/eng/043003.pdf)

The absurdities include a laughable miscasting of the events of the 1930s - there was no Murray Rothbard at work here, evidently - including an endorsement of a series of all too familiar actions taken by the Japanese (free depreciation of the yen, expansion of fiscal expenditures funded by government bonds underwritten by the BOJ, and the lowering of interest rates) which directly led to a destructive hyper-inflation.

Since these harmful nostrums are once again being actively implemented across the world, we thought we'd use a series of extracts from the section entitled, 'Deflation in the Nineteenth Century' as the basis for a commentary on how wrong-headed all this is.

'From a broader historical perspective, secular increases in the aggregate price level are very much a phenomenon of the second half of the twentieth century. [Note: Why this is so is much debated [SIC]. But one of the key reasons may well be the existence of discretionary monetary policy...'

Spot on! Global Keynesian inflationism rules!

'For much of recorded history, prices rose because of supply shocks, including military conflicts or harvest failures, but abstracting from these factors, prices were as likely to increase as decline: there were few episodes of sustained inflation. Over the nineteenth century as a whole, there was a marked decline in the aggregate CPI in several major economies.'

'In the United States, the CPI index in 1900 was around half its value in 1800; in the United Kingdom, it was a third lower. [Note: Taking an even longer period, the aggregate price level in the United Kingdom and the United States was virtually the same in 1900 as in 1700]'

You will also note, though it is here left unsaid, that, for much of recorded history, people grew richer (especially where personal liberties, property rights and the laws of contract were more honoured than violated), so deflation (under the loose IMF definition of falling aggregate prices) seems to have a pretty poor correlation with poverty.

'Prices declined in large part because of the constraints imposed by the Gold Standard in an environment in which there was a significant excess demand for gold. Increasing demand for money was being driven by technological change and population growth. At the same time, the supply of gold was largely fixed. The constraints imposed by the limited supply of gold manifested in part in the deflationary episodes and relatively weak growth: despite the extraordinary technological revolution, annual U.S. real GDP growth per capita was just above 1½ percent over the entire century; in the U. K. it was just under 1 percent.'

POP! There goes the whole glorious history of the prosperity and freedom brought by Manchester Liberalism, dismissed in a couple of paragraphs!

In fact, the statistics here seem to have been presented in a particularly prejudicial manner, in order to fit in with the authors' (foregone) conclusions about the imagined ills of general price declines.

Passing over our usual rant that GDP doesn't necessarily provide the best measure of societal progress, 1 ½% per annum is still a commendable rate of increase - implying that a man who started work at 16 and retired in his early sixties would have seen his real income double over that span.

Moreover, this passing slight also overlooks the fact of the expansion from 1800's 16 states, huddled on the Eastern seaboard and comprising a populace 5.1 million people, to a Continent-wide 45 states where over 74 million made their homes a century later.

Taken together, this implies a massive sixty-five fold increase in real GDP - and most of it originating in the private sector, too, rather than in the Military-Industrial-Congressional complex which swallows up so many resources today (with due exception being made for what one of our Southern friends refers to archly as 'The Late Unpleasantness').

'Although there is some debate on the precise effects of deflation specifically during the last quarter of the nineteenth century, there is a broad consensus [SIC] on the following: (i) periods of deflation were generally associated with significant social and political unrest as producers (especially farmers) faced rising debt burdens and bankruptcies; (ii) there was significant volatility in output growth, with deflationary periods marked by frequent financial crises; and (iii) periods of inflation, such as the last decade of the nineteenth century, had generally higher growth than periods of sustained deflation during the decade of the 1870s and early 1880s'

Talk about putting the cart before the horse! Growth was higher during inflation and lower during deflation? Even without contesting the interpretation of the data, this glibly argues that correlation is causation or, as professors like to put it, post hoc, ergo propter hoc.

For a more credible exposition, try this instead: 'The over stimulation of growth during Boom times, brought on, as ever, by state-endorsed, episodic credit inflation, inevitably led to a breakdown in the productive structure, from which naturally ensued a price revulsion as the contradictions inherent in misdirected production and misaligned costs and prices could no longer be sustained.'

'Nonetheless, GDP growth was on average positive in periods of deflation….'

Oh - so maybe it wasn't that bad, after all

'…There are two main explanations for this: First, periods of declining prices occurred at times of relatively favourable supply shocks. These included major episodes of diffusion of new technologies including the spread of railways and electrification…'

What? Capital deepening and investment occurring amid a deflation? How the Keynes can we explain that one?!? How did the 'animal spirits' of the entrepreneurs rise so high when prices were falling? Weren't there widespread worries about 'overproduction' and a lack of 'effective demand'? Didn't all this new technology put people out of work?

Or could it be that an increase in productive capital led to greater output which - some of this being saved and reinvested - thence opened up continuously greater possibilities for future capital increases and so on, in a virtuous circle whose reflection was the falling price of goods and services and the secular increase in real incomes?

'Second, prices did not fall long, or far, enough to lead to expectations of a deflationary spiral becoming entrenched. This hypothesis is supported by the behaviour of long-term interest rates that did not fall during deflationary episodes. Furthermore, financial intermediation played a less crucial role in the nineteenth century, and nominal rigidities likely were less entrenched than today…'

In other words, without a whole raft of 'stabilization' measures, 'counter-cyclical policy' and the tired old application of over easy money, our great grandfathers didn't perpetuate their mistakes, and so avoided eroding the nation's pool of resources, to the detriment of all, in a fruitless effort to postpone the admission that such faltering endeavours were economically unviable.

Rather, people swallowed their medicine, liquidated the malinvestments of the boom as expeditiously as possible and swiftly returned to rebuilding their wealth on a sounder basis. Without central banks, deficit spending governments and organized labour to intrude, busts didn't turn into lingering depressions.

Bring back Warren Harding!

Sean Corrigan
Capital Insight

Sean Corrigan is a principal of www.capital-insight.com, and a co-manager of  the Bermuda-based Edelweiss Fund.

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