Inflation versus Deflation

By: Ed Bugos | Tue, Feb 24, 2004
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Deflation Has to Be Deliberated

In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur. Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for very long - Ludwig von Mises, The Theory of Money and Credit - Chapter 13, section 7, "Excursus: The Concepts Inflation and Deflation" pp. 272

To exclude credit from the concept of money, particularly in defining inflation, is to ignore the lesson that was learned in 1845 when Sir Robert Peel - an economist from the British Currency School that opposed inflation but helped solidify central banking - attempted to restrict inflation by confining the policy to bank notes, rather than including bank deposits as well.

The subsequent financial crises that led to the suspension of Peel's Act in 1847, 1857, 1866, and 1919 revealed that Peel failed to understand how bank deposits were also money (fiduciary media) in the broader sense; but more importantly, von Mises (and Rothbard) pointed out that restrictionist measures could never really work in the first place so long as central banking existed, because central banks were government awarded monopolies exempt from market discipline... by definition. In other words, if things don't go their way, they could merely change the (legal tender or other) laws governing money. You all know this:

"The real obstacle in the way of an unlimited extension of the issue of fiduciary media is not constituted by legislative restrictions of the note issue, which after all, only affects a certain kind of fiduciary medium, but the lack of a centralized world bank or of uniform procedure on the part of all credit-issuing banks." (On Peel's Act - Chapter 20: Money and Banking; pp. 411, Section 2.2 in the Theory of Money and Credit)

The reason central banking is the engine of inflation is because it is the medium through which all banks under its umbrella come to agreement on the extension of credit. Without this, any individual bank that engaged in inflationary credit policies too quickly on its own would ultimately face a run on its reserves, perhaps initiated by one of its competitors who would know that it could not cover its outstanding notes.

Central banks are as much a cartel as OPEC is, but they are also a monopoly power awarded by the state - "an accumulation of legal privileges on a single bank."

The government benefits because it gets to borrow and spend beyond its means. Indeed, Murray Rothbard concluded that central banks were born of a "crooked deal between a near-bankrupt government and a corrupt clique of financial promoters" in 17th century England (though the first central bank was in Holland - recall Tulipmania).

Well, they couldn't do it without the public's help at any rate. For this truth would have been exposed long ago if the average person could not be fooled about the positives of central banking and inflationism... mo' money baby!

It is central banking that is barbaric, not gold.

Ignorance is not bliss. It is the food of slaves, and the tyrant's money.

Every year since 2000 I've put out a piece on the debate between inflation and deflation. And each time it has reflected the same conclusion. The Fed is stuck in an inflation trap of its own making. Events since have largely proven us correct.

However, this does not quite mean that it must continue to inflate in order to avoid deflation. At this point in the cycle it is probably more accurate to say that it must continue to inflate in order to support the illusion that underpins the value of the US dollar as a common medium of exchange. In lay terms, they gotta' keep it going.

However, the consequence of ending it now is not deflation, but rather, hyperinflation.

I'm using the word 'hyperinflation' loosely to depict a circumstance where the Federal Reserve Note loses its value not merely because the central bank expands its quantity (the supply side) without abandon. Such a policy anyway is the result of hastily reacting to valuation judgments by individuals already underway, toward a quickening diminution of the monetary value of the currency - or fiduciary media today.

In other words, the demand side has something to say about it all.

When I talk about the impact of inflation on the value of the currency, many people presume that I'm applying the simple version of the quantity theory. It's not true. I don't contend that a 20% increase in the supply of money would translate into a proportionate decrease in the value of the currency.

In fact, no devaluation can occur at all so long as the individual economic agents making up a given market do not alter their demands for money in such a way as to allow it. The increase in supply of money tends to cause an increase in the stock of money for those that receive it first. But there is nothing automatic or mechanistic about the actions that follow, and which determine the impact of that increased supply of money on its value through the subjective valuations of individuals.

The incorrect (or older) application of the quantity theory would suggest otherwise. It would ignore the individual subjective valuations of individuals altogether. Of course, such valuations aren't predictable.

If they were, money would not be necessary to begin with.

Nevertheless, it is ignorant to throw out the quantity theory altogether, because it can't be disputed that the interaction between supply and demand does invariably affect the value of money much like it does any other economic good - except on a different basis... as a medium of exchange, not as capital, and not as a consumption good.

The criticism levied against the mechanistic version of the quantity theory is correct; but to throw it out altogether is like throwing the baby out with the bathwater. All that has to be done is to take into account how the demand side actually works.

The point I'm getting at is that it is the market that decides what is money, and what its value is. And this is in part determined by its relative scarcity as an economic good. i.e. Individuals must not believe that the policy of inflation can go on indefinitely.

This is the mission statement the Federal Reserve should post on its website instead of the lie: "The Federal Reserve, the central bank of the United States, was founded by Congress in 1913 to provide the nation with a safer, more flexible, and more stable monetary and financial system."

In developing the theory of the value of money, Ludwig von Mises observed that at the point where people finally see that the policy of inflation is endless, the "crack up boom" begins, and ends in the abandonment of the current medium as money:

"But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap pater. Nobody wants to give away anything against them. It was this that happened with the Continental currency in America in 1781, with the French mandats territoriaux in 1796, and with the German Mark in 1923. It will happen again whenever the same conditions appear. If a thing has to be used as a medium of exchange, public opinion must not believe that the quantity of this thing will increase beyond all bounds. Inflation is a policy that cannot last" - Ludwig von Mises, Human Action, Chapter 17, "Indirect Exchange, the anticipation of expected changes in purchasing power

The comment that "inflation is a policy that cannot last," does not mean that it results in deflation; it means that eventually the currency is no longer money.

In 1923 Germany, the story goes, a woman brought a basket full of Reichmarks to her baker in order to purchase a loaf of fresh bread. She succeeded at persuading the baker to give up the goods. The thing is, he threw the marks out and kept the basket.

At this point, even if the central bank tightened monetary policy, presumably it would have been too late... people would know it was to be temporary.

Consistently and uninterruptedly continued inflation must eventually lead to collapse. The purchasing power of money will fall lower and lower, until it eventually disappears altogether. It is true that an endless process of depreciation can be imagined. We can imagine the purchasing power of money getting continually lower without ever disappearing altogether, and prices getting continually higher without it ever becoming impossible to obtain commodities in exchange for notes. Eventually this would lead to a situation in which even retail transactions were in terms of millions and billions and even higher figures; but the monetary system itself would remain.

But such an imaginary state of affairs is hardly within the bounds of possibility. In the long run, a money which continually fell in value would have no commercial utility. It could not be used as a standard of deferred payments. For all transactions in which commodities or services were not exchanged for cash, another medium would have to be sought. In fact, a money that is continually depreciating becomes useless even for cash transactions. Everybody attempts to minimize his cash reserves, which are a source of continual loss. Incoming money is spent as quickly as possible, and in the purchases that are made in order to obtain goods with a stable value in place of the depreciating money even higher prices will be agreed to than would otherwise be in accordance with market conditions at the time. When commodities that are not needed at all or at least not at the moment are purchased in order to avoid the holding of notes, then the process of extrusion of the notes from use as a general medium of exchange has already begun. It is the beginning of the "demonetization" of the notes. The process is hastened by its paniclike character. It may be possible once, twice, perhaps even three or four times, to allay the fears of the public; but eventually the affair must run its course and then there is no longer any going back. Once the depreciation is proceeding so rapidly that sellers have to reckon with considerable losses even if they buy again as quickly as possible, then the position of the currency is hopeless
- Ludwig von Mises, The Theory of Money and Credit - Chapter 13, section 3, "Inflationism" pp. 258/259

If the older mechanistic version of the quantity theory were applied this point could never be reached. The currency would just continue to devalue in proportion to the increase in supply indefinitely, and all prices would rise, to the same degree, and proportionately, forever. It doesn't take a genius to refute this in the real world. It doesn't even take a lot of knowledge of history. One needs only look to the example of the late nineties to see that an increase in the supply of money doesn't translate into a currency debasement, either immediately or proportionately.

Today, even among gold bulls, there is this feeling that the consequence of the profuse inflation that we've experienced in credit over the past two decades will be deflation, and that even as the prices of all things fall, gold will alone rise.

I full-heartedly reject this view on both counts. The example of Japan's circumstances is wholly inapplicable because we've already shown that deflation is not defined merely by what happens to the general price level. Japan's model is convenient to the Fed because it represents conditions that nobody wants.

However, the Yen is not money outside Japan any more than the Canadian dollar is money outside Canada. And inside Japan or Canada, these currencies are money only because they are freely convertible into the US dollar, which happens to be the most common medium of exchange in the world trade arena.

The US dollar competes with gold directly for this position. The Yen is merely an instrument of mercantilist policies. The US dollar is too, but it is not yet understood in that light. It will be this decade.

The United States experienced an enormous deflation in the short period from 1930-33. It is true that the cause of these conditions should be connected to the preceding policies of inflationism. However, it is wrong to conclude that there is some natural economic law, which dictates that deflation follows inflation. Any contraction in the money supply that occurred during this time was due solely to the workings of the gold standard.

Because the US dollar was fully convertible to gold at a fixed value at the time, when the inflationary boom turned to bust, people preferred to exchange their overvalued bank notes (or dollars) for gold - this was the driving force behind the bank runs that caused a drain on real monetary reserves (gold) and culminated in Roosevelt's bank holiday, and which ultimately resulted in the inevitable devaluation of the dollar as well as the final abandonment of the gold standard.

The option of exchanging bank notes for gold no longer was allowed. People had little choice but to accept this state of affairs - the motivation for the exchange having been outlawed altogether - and paper reserves of course are easily inflated.

But it was not some flaw of gold, or natural market forces per se, or the greed of people that caused the bank runs which led to the subsequent deflation.

It was the consequence of the preceding policy of inflationism UNDER a gold standard. It could be argued that the particular gold standard was inadequate in so far as it did not restrict the inflation in the first place.

In any case, while gold was fixed, gold stocks rose after the crash of 1929, and accelerated through 1933, then blew off in 1935. But by 1935, prices no longer fell. The CRB bottomed in 1933 as the gold standard was abandoned. The fact that gold stocks rose then was not evidence that gold rises during periods of deflation.

Rather, I would contend, they rose because gold stock investors already knew that the road the economy was on would lead to more inflation not less, much like we knew three years ago that the Bernanke's of the world would take over the reigns at the Fed.

In other words, the market correctly anticipated the abandonment of the gold standard, which was already telegraphed at least a decade earlier. After all, the rhetoric of the day was already aimed at blaming the gold standard for the state of affairs.

If instead of FDR, for instance, someone like Thomas Jefferson would have won office who objected to central banking, you can bet your golden parachute that gold stocks would not have acted nearly as well because odds are he would have placed the blame where it should have been placed - on central banking, not gold.

Had the gold standard remained, undoubtedly more banks would have failed, and deflation would have continued for a while.

Whether that is a desirable outcome or not is besides the point here. The point here is merely that deflation is not an automatic result of money or credit inflation, and that gold doesn't rise in value during deflation - defined as a contraction in money supply - unless the value of each unit of the shrinking supply of money is also falling, in which case other commodities would also rise in value... though to a lesser extent.

This was the case after 1933, and it was also the case after 1971. It is the case during ever case of US dollar devaluation in history.

A real gold standard is supposed to stand in the way of the policy of inflationism, and the welfare state, as Greenspan articulated in his essay published by Ayn Rand in her book, "Capitalism, The Unknown Ideal," in 1952.

However, the reason it didn't in the 1920's or afterwards during the reign of the gold exchange standard known as Bretton Woods has already been shown... because central banking itself is the engine of inflation. Without it, and the legal tender laws that support it, the kind of inflation we are used to wouldn't have a chance.

Banks could inflate only slowly, and any excessive inflation would be quickly corrected.

The conditions under which a gold standard would work exclude central banking, or any government regulated expansions in notes (as in the United States before the Civil War when States pushed for the expansion of fiduciary media).

Contrary to popular opinion, Rothbard showed that free banking never existed in the United States. But the fact that people think it did lends weight to the argument that markets are inherently unstable, because there were numerous financial crises even before the Fed came to be. Sure banking was decentralized, but it was a matter of different states with different inflation policies regulating banking affairs, not the market.

The inhibiting factor that would have prevented each individual bank from inflating (market discipline) and would have ensured a greater financial stability was already absent. At least in terms of banking, capitalism is indeed the unknown ideal.

Nobody is claiming that markets are stable... just more stable without intervention than with it. Denying this amounts to denying that individual valuation judgments can neither be predicted nor ignored.

Socialist policies always tend to produce instability precisely because they deny the importance of the individual in the role of resource allocation. Regulation is akin to intervention. And laws generally do not produce a level playing field for anyone but the cartels they protect - from prohibition to legal tender to insider trading.

Don't get me wrong. I am not condoning the practice of insider trading. I just don't believe laws work to regulate it. They just keep the little guy from having the same advantage as the big fish. I'll tell you this, moreover. Having received plenty of insider tips myself, I have never once acted on any of them. There is good reason for it. Most such tips are plain bad, and I've done better at outguessing the market than I would have if I traded solely on inside tips.

However, if inside trading were allowed, it would be more easily visible in the tape. Any technician could spot it in an instant. The important thing is, the bad tips would rarely show up in the chart in the first place.

Hence, the regulation governing insider trading is not so much a matter of protecting a cartel of inside traders, as it is a matter of unnecessary costly regulation for the financial industry resulting in higher trading costs for individuals.

It's just my opinion. I mention it only to highlight the lack of faith people today have in the market itself for producing stability, prosperity, and disciplining participants.

There are only three ways to have deflation today, and one of them is to fake it: a) a deliberate deflation policy, b) linking the dollar to a gold standard (which is the same as "a"), and c) the debasement in the dollar overshoots for the time being (this is the fake, like the one experienced in the early eighties).

In the third example, note that gold fell during the early eighties.

But it is important to realize that there hasn't been a true deflation since the gold standard was abandoned in 1933. And for good reason - there is nothing to restrict the central bank from inflating, nothing.

Even if one imagines a blow up in the government sponsored entities that have come to dominate the mortgage markets and are the largest single medium of inflation outside of the central bank, he or she must concede that this would result in a devaluation of the US dollar if only due to the extent of foreign ownership of the dollar denominated paper.

And it should be clear that if Fannie or Freddie were to blow up today, that the Fed is committed to its policy of inflation - which is limited only by the imagination of its governors in how to print more currency. The analogy of Fed governors throwing money out of a helicopter if they had to is appropriate, and prevented only by the knowledge that the party would come to an even quicker ending if it came to that.

Thus, the inflationary response to current circumstances is as predictable as it was in the thirties, and seventies. It is true that there have been circumstances in the past where central banks employed the policy of deflation under the belief that they could fix the consequences of prior inflations. But their resolve never lasted, and it was only ever employed as a matter of last resort.

This was somewhat true of the actions of the Fed in the late 1970's when Paul Volcker was appointed Chairman. By 1979, the US stock market was trading at a paltry 10 times earnings, the dollar had lost about 75% of its value (according to gold), and interest rates were already exploding skyward.

Thus, by then there was little left to do but head off the "crack up" boom as best as possible - i.e. to preserve whatever credibility the central bank could. There was nothing left to lose. This is not yet the case today.

Had the Fed turned hawkish in 1973 when the dollar was only beginning to crack, it would have received the blame for what was to follow with or without the intervention.

This is the case today. If the Fed decided to adopt a restrictionist policy now to correct the malinvestments and other consequences of the last two decades of credit inflation, markets and banks, and maybe even governments would all but fold. The devaluation in the dollar would not be avoidable. It is already inevitable, but they'd be blamed.

The resolve that is required to contain it does not exist, as has always been the case. The policy response to the current state of affairs is and always has been more money and credit inflation.

It is ridiculous to suggest that Paul Volcker succeeded at eliminating inflation. All that he accomplished was to preserve the credibility and increase the power of central banking for a while longer. All of the causes and consequences of inflation exist today the same as they always have.

The key is to keep people believing that the policy is not endless.

While the Inflationists targeted gold in 1933 as the cause of their problems, they could not prevent its increase in value. No law could ever do this, as was realized in the seventies when individuals were again allowed to trade and own gold (from 1934 to the mid seventies there were severe penalties for owning gold in the United States).

Although the threat of outlawing the ownership of gold is real today, it could only be a naïve population that could allow it under the belief it could work, or that it was the cause of our troubles. I believe it is a much harder task today to blame gold.

But maybe my faith in individuals will be tested yet.

The bottom line is that there is little possibility of deflation today, and that any contraction in money supply is temporary barring some new found resolve by central banks to liquidate the boom themselves, deliberately.

The fear of deflation is a deliberate ploy provoked by central banks trying to justify the ongoing policy of inflation, as well as to manage inflation expectations thus cap interest rates - all designed to keep people from believing that the policy can go on indefinitely, and to keep them from ending the boom prematurely.

The actions the Fed has taken are indeed aggressive. But as we said four years ago, it is because they are in an inflation trap where they have no choice but to keep inflating in the hope that the bubbles they create can continue to generate fresh interest for the currency, thus sustain their BOP imbalances, create jobs, and keep the government solvent. Their policy response was entirely predictable, and believe me, the true motivation is far removed from the fight against the deflation bogeyman!

A few concluding remarks here.

First, deflation would not necessarily be the norm under a pure gold standard, but if it were, it would be mild so long as there is no credit excess that leads to a bust. The more inflation, the more deflation - but only under a gold standard... otherwise it's just more and more inflation.

Second, capitalism is not prone to boom-busts, at least not the extent to which we've experienced in the 20th century. That is the obvious result of inflation policy!

Third, capitalism does tend to produce falling prices, but it is not deflation, and it is not severe if it isn't caused by an unwarranted expansion in money to begin with. The value of your dollar increases! You can buy more goods. This is what capitalism is supposed to do. Productivity translates directly into more real wealth this way.

Last but not least, all prices do not rise or fall at the same time during a debasement.

The prices of goods overproduced during the boom in credit could fall even during the subsequent currency devaluation.

Some people seem to think that inflation means the overproduction of all things. This is absurd because it ignores the fact that in a given economy, its productive resources are scarce in the first place. Inflation causes them to be misdirected... towards the overproduction of the wrong goods, and/or uneconomic enterprise.

Thus, while some things are overproduced, others, like gold, tend to be under-produced during the best part of the artificial boom in paper. When the paper boom busts and THE MARKET devalues the currency, the relative scarcities become increasingly apparent.

I am not stubborn about this. If anyone can refute my arguments about deflation, or show me how deflation is possible regardless, I'd be happy to listen.

But I will not entertain any arguments that suggest:

a) Central banks are somehow restricted from inflating money by the market in the absence of a gold standard
b) Deflation is simply falling prices, as opposed to contracting money
c) Falling asset values somehow manifest in stronger currency values
d) Inflation automatically results in deflation
e) The value of money is determined only by its supply, or by the government or banking cartel's wishes

Such arguments have long been shown to be fallacious.

Massive currency devaluations in the midst of a monetary bust do cause interest rates to rise, but the rise in interest rates does not immediately cause the currency to find support, or cause deflation. If they did, the seventies crisis (or commodity boom) wouldn't have lasted the whole decade.

Gold is rising in value today because the market knows this to be true, as was the case in the late sixties and the twenties. And to the extent that the majority of people don't believe it, yet, they merely represent a pool of skeptics from which the bull market in gold will thrive until they do... until the pool is empty.

So the fact that even in the gold camp there are those who forecast deflation is but another signal that the bull market in gold is young. It means the market isn't yet generally aware that the policy of inflation is endless.


Ed Bugos

Author: Ed Bugos

Edmond J. Bugos

Ed Bugos is a former stockbroker, founder of, one of the original contributing editors to and former editor of the Gold & Options Trader. He continues to publish commentary on market and economic trends; and provides gold, economic and mining research to private clients worldwide.

The editor is not a registered advisory and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

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