Chapter 22 of 26 · Capitalism: A Treatise on Economics by George Reisman
Chapter 19. Gold Versus Inflation
CHAPTER 19
GOLD VERSUS INFLATION
PART A
INFLATION OF THE MONEY
SUPPLY VERSUS ALTERNATIVE
THEORIES OF RISING PRICES
1. The Analytical Framework of the Quantity
Theory of Money
The quantity theory of money, as developed earlier in this book, shows that the cause of generally rising prices is an increase in the quantity of money. More specifically, it shows that the cause is an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver. The increase in the supply of gold and silver, being itself a by-product of the general increase in the ability to produce, would show no tendency regularly or significantly to outstrip the increase in the supply of the mass of ordinary commodities, and to that extent would be incapable of causing a sustained significant rise in prices. In addition, since government intervention into the monetary system is what has been responsible for the quantity of money being able to increase more rapidly than the increase in the supply of gold and silver, the quantity theory of money implies that what is responsible for the problem of a persistent significant rise in prices is an increase in the quantity of money caused by the government.
Indeed, the quantity theory of money implies that inflation should be defined in terms of the increase in the quantity of money—specifically, as an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver or, equivalently, as an increase in the quantity of money caused by the government. Such a definition states the essential cause of the cluster of symptoms which people identify with inflation and which must be acted upon to eliminate those symptoms. It represents a definition in terms of fundamentals and provides, at the same time, a sound guide to corrective action. Nevertheless, the great majority of people today, including even the great majority of professional economists, define inflation in terms of one of its leading symptoms. They define it merely as rising prices.
The definition of inflation as rising prices says absolutely nothing about any specific cause of rising prices. It implies, therefore, that inflation can be caused by anything that raises prices.
Having accepted this definition, it is no wonder that people are confused about inflation. There are a vast number of things that might raise prices in one circumstance or another, ranging all the way from bad weather causing poor crops and thus higher farm-product prices to the development of a fad for some novelty. On the basis of the definition of inflation as rising prices, people are led to consider every possible cause of higher prices as a possible cause of inflation, and thus to believe that the cause of inflation can vary from case to case.
Thus, they believe that inflation can be caused, variously, either by “demand pull,” that is, by more spending outstripping the growth in the supply of goods and thus “pulling up their prices,” or by “cost push,” that is, by
rising costs forcing up prices. (The quantity theory of money is often thought to operate exclusively in the form of “demand pull” and is thus classified by many economists under the heading of “demand-pull inflation.”) 1
By “cost-push inflation” is meant, frequently but by no means always, the arbitrary demands of labor unions, which drive up wage rates and thus costs of production and prices. This variety of cost-push inflation is called “wage-push inflation.” In addition, there is supposed to be a second variety of cost-push inflation, namely, “profit-push inflation,” which allegedly occurs when the greed of businessmen is supposed to drive up the prices of critical raw materials, such as steel and cement, which in turn constitute costs of production to large numbers of other producers. The term profit-push inflation is also applied to cases in which the greed of businessmen selling consumers’ goods is supposed to drive up the prices of the consumers’ goods directly, without any rise in costs of production. (To incorporate this type of case, the term “sellers’ inflation” is sometimes used in place of “cost-push inflation.”)
Yet a third variety of cost-push or sellers’ inflation is supposed to exist in cases in which this or that crisis, such as the Arab oil embargo or the sale or giveaway of large quantities of wheat to the Soviet Union, disrupts the supply of one or more vital goods and so raises the costs of production of all the producers who require them. This species of cost-push inflation is sometimes termed “crisis-push inflation.”
Closely related to the doctrine of cost-push inflation is the doctrine of the “wage-price spiral.” According to this doctrine, prices rise because wages rise, and wages rise because prices rise. Wages and prices, it is believed, simply chase each other upward in a spiral, and that is why prices go on rising. (If a proponent of this doctrine is sympathetic to labor unions, he asserts that the process begins with an arbitrary rise in prices due to the profit-push of employers. If he is unsympathetic to labor unions, he asserts that it begins with an arbitrary rise in wages due to the wage-push of the unions.)
Socalled demand-pull inflation is also supposed to take a variety of forms. In addition to being caused by an increase in the quantity of money, it is supposed to be capable of being caused by inexplicable increases in the velocity of circulation of money; by the unexplained existence of “inflation psychology”; by the growing use of credit cards, installment credit, or other forms of credit; and even by the sheer increasing greed of consumers for more goods.
The effect of believing that “inflation” can be caused by an extensive list of things that the mind has no clearcut way of organizing or holding is that for all practical purposes people are led to regard inflation as causeless. Ask the average person—or even many professors of economics—what causes inflation, and at most a blur of confused bits and pieces of knowledge about what might raise prices in this or that case comes to his mind. For all practical purposes he has absolutely no idea of the cause. For he believes that to determine the cause in the specific case at hand requires a special investigation, to determine which of all the various alleged possibilities is the actual explanation. On this basis, we can observe the appointment of successive panels of alleged experts to study the problem of inflation, as though the explanation had never been found.
But this is not the worst consequence of the definition of inflation as rising prices. For that definition not only opens the door to too-wide a range of possible explanations to be of any value. It also directly and powerfully suggests one particular, extremely simple explanation, which in fact is the most popular explanation—namely, that inflation is the result of the ill will of evil, powerful people: above all, of big businessmen driven by the greed for higher profits. This is necessarily the most popular explanation of inflation, given the general acceptance of its definition as “rising prices.”
This is because if inflation is defined simply as being rising prices, then it follows that inflation only comes into existence when businessmen raise their prices and exists only to the extent that they raise their prices. In other words, it follows from the current definition that inflation exists when and to the extent that someone— Jones, the corner grocer, General Motors, or whoever— raises his price. It follows further that inflation would not exist if Jones or whoever did not raise his price. In the absence of any clearcut understanding of why Jones or whoever must raise his price, there is no way that people can avoid concluding that Jones or whoever is responsible for inflation.
The real view that most people have of inflation, therefore, is that it is something caused by the evil of private individuals, especially greedy businessmen.
This view of the nature of inflation suggests an apparent and seemingly logical remedy: the government, motivated by concern for the public welfare, should forbid the evil businessmen to raise their prices. Price controls, it appears, are the solution to inflation.
And just as inflation stands in people’s minds as a causeless phenomenon born of mere ill will, so price controls are regarded as having no effects but that of stamping out inflation. In the view of most people, what we have in the matter of inflation and price controls is a causeless evil overpowered by an otherwise effectless good. To put this another way, what most people do in the matter of inflation and price controls is to begin their thinking at the point of the businessman raising his
GOLD VERSUS INFLATION 897 prices, and to end it at the point of the government entering the scene with a Verbot. All that comes before and all that follows after is a blank in their minds.
I have already explained both the effects of price controls and the actual cause of rising prices. My purpose here is to reinforce the quantity theory of money by refuting all of the other explanations of rising prices that have been advanced. I will show that all of the alternative explanations are either simply false or else, to the extent that they do contain some modest kernel of truth, constitute merely a further confirmation of the truth of the quantity theory of money. I will show that the increase in the quantity of money is not merely one possible cause of rising prices among many possible causes, but is the universal cause of every sustained significant rise in prices. At the conclusion of the first part of this chapter, it will be apparent, if it is not already, that as a means of furthering both our understanding and our ability to deal with the problem, inflation should not be defined as rising prices, but in terms of the universal underlying cause of rising prices. That is, to repeat, inflation should be defined either as an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver or, equivalently, as an increase in the quantity of money caused by the government.
The Vital Demand/Supply Test for All Theories of
Rising Prices
The equation, initially developed in Chapter 12, that
P = D C
S C
—i.e., the general consumer price level equals the aggregate demand (spending) to buy consumers’ goods, divided by the aggregate supply of consumers’ goods produced and sold—provides an indispensable conceptual framework for examining any possible explanation of rising prices and for confirming the truth of the explanation based on the quantity theory of money.
When people speak of inflation as a rise in prices, what they really have in mind is not an isolated rise in some prices here and there, offset by a fall in prices elsewhere, but a rise in the generality of prices. The general consumer price level is the weighted average of all consumer prices. As previously explained, the supply it reflects is the sum of all consumers’ goods produced and sold, conceived of as so many units of an abstract consumers’ good in general. This supply is purchased for a definite aggregate expenditure of money. The result is the general consumer price level.
The above equation, it must be recalled, shows the general consumer price level to be the resultant of a numerator, demand, divided by a denominator, supply.
The average price at which goods are sold is the spending to buy them divided by the quantity of them sold. It follows from this equation that there are only two conceivable ways in which the general consumer price level can rise. Namely, either the demand for consumers’ goods must rise or the supply of consumers’ goods must fall. If neither of these conditions is present, then it is absolutely impossible for the general consumer price level to rise. For there is simply no conceivable way that it could. Its rise in such circumstances would constitute a contradiction of the laws of arithmetic: it would be a rise in a quotient without a rise in the numerator or fall in the denominator, which is to say, an absolute impossibility.
This reduction of the possible causes of rising prices to just two does not actually rule out the existence of other possible causes, provided those other causes operate by way of producing more demand or less supply. More demand or less supply are the only conceivable proximate or direct causes of a higher price level. There is thus still the possibility of all kinds other, mediate or indirect causes of higher prices. However, the reduction to just these two proximate causes imposes a critical test on any other alleged cause. Namely, in the nature of the case, any cause of higher prices other than more demand or less supply must produce its effects by means of causing either more demand or less supply. If there is something which is alleged to be a cause of higher prices other than more demand or less supply, and it cannot be shown how it raises demand or reduces supply, then it must be dismissed as a cause out of hand. More demand or less supply are the necessary, indispensable connection between higher prices and any alleged other cause of higher prices. If they are absent, there simply is no connection between that alleged cause and higher prices.
The quantity theory of money connects the increase in the quantity of money to the rise in prices by way of establishing a connection to more demand. As previously explained, a growing quantity of money raises the demand for consumers’ goods through the new and additional money being spent and respent and, as its rate of growth becomes more substantial, through bringing about a decrease in the demand for money for holding and thus a rise in the velocity of circulation of money. 2 Every other possible explanation of rising prices must pass a similar test of linkage to the growth in demand or decline in supply if it is to be considered.
The Elimination of Less Supply as the Cause of an
Inflationary Rise in Prices
Our analytical framework for examining theories of the rise in prices is carried a long way forward when it is realized that decreases in supply must be eliminated from
consideration as the cause of a rising price level, both here in the United States and everywhere else in the world. There are seven reasons for eliminating reductions in supply. They are as follows.
i. The Actual Influence of Supply Has Been to Reduce Prices
In almost every year since World War II, which is the period complained of as marked by inflation, prices have indeed risen in the United States, Western Europe, and Japan. Yet, over the same period of time, supply has actually increased rather than decreased in these places, and it has done so in practically every year. Supply has increased enormously, as the result of a larger population, and, consequently, more people working; and, even more, as the result of technological progress and capital accumulation, which have raised the productivity of labor and thus enabled each worker on average to produce a greater output.
Our formula for the general consumer price level, of course, shows that the effect of increases in supply must be to reduce prices in inverse proportion. The fact that the price level has risen, therefore, despite vast increases in supply, can be ascribed only to the influence of even more substantial increases in demand. The problem of rising prices in the United States and every other leading country over the last fifty years or more is clearly one of rising demand, not falling supply.
ii. Where Falling Supply Has Contributed to Rising
Prices, Its Role Has Been Relatively Minor
Of course, there are some countries in which supply has fallen, and fallen quite substantially, at least over portions of the period since World War II. Chile in the early 1970s and Uruguay in the 1960s are leading examples. While the precise extent of the fall in supply in these countries may be difficult to estimate, it is extremely doubtful that in the worst period the cumulative decrease ever exceeded a figure of 50 percent. If, for the sake of argument, we take the figure of 50 percent, we could account for a doubling of the price level in these countries on the basis of supply reductions. I say a doubling, because our formula for the general price level shows that a halving of supply coupled with an unchanged demand must produce a doubled price level. However, as is wellknown, the price levels in countries like Chile and Uruguay have not increased by a factor merely of two over any extended number of years. An increase of this order of magnitude frequently occurs in a single year in those countries. In any given decade, prices in those countries have increased probably by a factor of fifty or more. And since World War II, they have increased by a factor of many thousand. Therefore, even where supply has decreased, the overwhelmingly greater part of the rise in prices cannot be accounted for on the basis of reductions in supply, but must be ascribed to increases in demand.
iii. Reductions in Supply as the Cause of Rising
Prices Imply the Rapid Disappearance of
Material Civilization
Reductions in supply could explain a sustained significant rise in prices only if material civilization were in the process of rapidly disappearing, which, of course, it is not. For the pricelevel formula implies that every rise in the price level ascribable to a decrease in supply requires a decrease in supply that is inversely proportionate. This is because when changes in supply are supposed to be the operative factor, demand must necessarily be assumed to be unchanged. As a result, in the case of rising prices caused by falling supply, a rise in the price level means a rise in a quotient accompanied by a fixed numerator (demand). This implies a denominator (supply) that falls in inverse proportion. Thus, for example, a doubling of prices caused by a decrease in supply requires an actual halving of supply. In the same way, a tripling of prices ascribable to a fall in supply implies a reduction of supply to one-third of its initial level; a quadrupling, to one-fourth, and so on.
If a sustained rate of increase in the price level, such as 5 percent, 10 percent, or 100 percent per year, is to be ascribed to supply reductions, it follows that in each year, supply would have to fall in inverse proportion to the rise in prices. It further follows, therefore, that if any sustained, even moderately significant rate of increase in the price level were to be ascribable to supply reductions, the virtual disappearance of material civilization would be implied within a fairly short period of time. For example, in the course of a single generation, a 5 percent annual rise in prices based on supply reductions would mean that year after year, for a generation, supply would be on the order of 5 percent less than it was the year before. This would imply a cumulative reduction in supply to about one-third of its initial level, since at a 5 percent compound rate of increase, prices would approximately triple in a generation. If falling supply is to be the explanation of a tripling of prices, the fall would have to be all the way to one-third. With the same demand numerator, only such a fall in the supply denominator is capable of raising the pricelevel quotient by a factor of three.
Similarly, a 10 percent annual rise in prices, based on supply reductions and sustained for a generation, would imply a reduction in supply to about one-eighth of its initial level. This is because at a 10 percent compound annual rate of increase, prices double in approximately eight years. Thus, in a generation, which encompasses
GOLD VERSUS INFLATION 899 more than three periods of eight years, in each of which prices double, prices must increase by more than two raised to the third power, that is, by a factor of more than eight. If falling supply is to be the explanation of an eightfold rise in prices, the fall would have to be all the way to one-eighth.
Even a mere 2 percent annual rise in prices caused by falling supply implies a halving of supply every thirtyfive years and thus a reduction in supply to one-eighth of its initial level in the course of little more than a century. This is a more rapid rate of decline than was experienced by the Roman Empire in its decline. Thus it is not possible to explain a sustained rise in prices even as moderate as 2 percent a year on the basis of falling supply, without the very rapid disappearance of material civilization being present.
iv. Falling Supply Is the By-Product of Rapid
Increases in Aggregate Demand
Furthermore, if we look at countries like Chile and Uruguay, which actually experienced significant supply reductions, it becomes obvious that most or even all of the reductions in supply that occurred were themselves the result of the rapid increases in aggregate demand that took place in those countries. A rapidly rising aggregate demand disrupts production. The rapid rise in prices it brings about causes widespread discontent and foments crippling strikes, and even sabotage. In these ways, and others that are more substantial, and which will be explained in Part B of this chapter, a rapidly rising aggregate demand acts to reduce production and, therefore, supply. Thus, a decrease in supply is often itself merely an indirect consequence of a rapidly rising aggregate demand, rather than being an initiating cause of rising prices.
v. Falling Supply Cannot Explain the Range of Price
Increases that Exists Under Inflation
Even such supply reductions as are not themselves caused by rising demand, and which, therefore, may legitimately be said to be an independent cause of higher prices—for example, poor crops due to bad weather— should not be described as a cause of inflation, despite the fact that they raise the general consumer price level. This is because they do not produce the range of price increases that people associate with inflation. When people complain of “inflation,” they have in mind more than a mere rise in the weighted average of consumer prices that is depicted in the consumer pricelevel formula. They have in mind a condition in which almost every individual price rises and hardly any individual prices fall. It is highly doubtful that they would complain of inflation if a large number of individual prices actually fell, even if, at the same time, the consumer price level, in the sense of the weighted average of consumer prices, rose. Yet precisely this phenomenon of widespread price declines would be the effect of reductions in supply that were not accompanied by increases in demand. If supply fell without being accompanied by an increase in demand, the effect would be that a whole host of prices would actually fall, even though the weighted average of prices rose.
A large number of prices would fall, because the effect of a reduction in supply would be to make people poorer. As they became poorer, they would concentrate a larger and larger proportion of their limited demand on necessities and a smaller and smaller proportion on luxuries. The prices of all luxury and semi-luxury items would therefore tend to fall.
To understand this result, consider the wellknown fact that decreases in the supply of necessities produce more than proportionate increases in their price. A 5 percent reduction in the supply of wheat, for example, might raise its price by 25 percent, or more, because the price of a necessity must rise steeply before people are deterred from buying it. This kind of situation implies a shifting of spending away from comparative luxury goods, to wheat, or to any other necessity or comparative necessity in decreased supply. People have the money to pay the disproportionately higher prices of necessities in reduced supply only by taking money away from the purchase of luxuries. And that acts to reduce the price of luxuries. The principle here is that a drop in the supply of any good that comparatively speaking is a necessity causes spending to shift to it from goods that comparatively speaking are luxuries. Its price rises more than in proportion to the drop in supply, and their prices actually tend to fall.
Similarly, if the supply of any good falls that is employed with other, complementary goods, its price tends to rise disproportionately, while their prices actually tend to fall. For example, a drop in the supply of gasoline causes a sharp jump in the price of gasoline and, at the same time, acts to reduce the demand for automobiles, motel rooms, and so on. The prices of such things, therefore, tend to fall, and actually would fall if the quantity of money and demand in the aggregate did not rise and thus hold up or even increase the demand for them at the same time that people concentrated their expenditures more heavily on the goods in reduced supply.
The phenomenon of large numbers of prices actually falling as the result of declining supplies would be a continuing one as supply fell and the weighted average of prices rose from year to year. In one year, the prices of luxury goods and various complementary goods would
900
CAPITALISM
Figure 19–1
Falling Production and
Year 1
Opening
Assets 1K OF CAPITAL GOODS of Business: at a Cost Value of 400
Transactions: Demand for
Capital Goods: 500
Production:
40% Year 2
Opening
Assets .8K OF CAPITAL GOODS of Business: at a Cost Value of 320
Transactions: Demand for
Capital Goods: 400
Production:
40% Year 3
Opening
Assets .64K OF CAPITAL GOODS of Business: at a Cost Value of 280
Transactions: Demand for
Capital Goods: 400
Production:
40% Year 4
Opening
Assets 1.512K OF CAPITAL GOODS of Business: at a Cost Value of 280
Transactions: Demand for
Capital Goods: 400
Supply Under an Invariable Money
1,000 Units of 1C OF CONSUMERS’ GOODS Cash to Be Paid Out at a Cost Value of 400
Demand for Wages: 300+Net Cons.: 200
Consumers’Goods: 500
1 K OF CAPITAL GOODS AT 500
PLUS 1L OF LABOR
AT 300 PRODUCE
60%
1,000 Units of 1.2C OF CONSUMERS’ GOODS Cash to Be Paid Out at a Cost Value of 480
Demand for Wages: 300+Net Cons.: 300
Consumers’Goods: 600 l.8 K OF CAPITAL GOODS ATl
400 PLUS 1L OF LABOR
AT 300 PRODUCE
60%
1,000 Units of .96C OF CONSUMERS’ GOODS Cash to Be Paid Out at a Cost Value of 420
Demand for Wages: 300+Net Cons.: 300
Consumers’Goods: 600 l.64K OF CAPITAL GOODS ATl
400 PLUS 1L OF LABOR
AT 300 PRODUCE
60%
1,000 Units of aaa.768C OF CONSUMERS’aaa
Cash to Be Paid Out GOODS at a Cost Value of 420
Demand for Wages: 300+Net Cons.: 300
Consumers’Goods: 600
fall as the prices of various necessities and certain complementary goods sharply increased. In the following year, as capital was withdrawn from the production of luxury goods and invested in the production of the necessities whose prices had sharply increased, the prices of those necessities would fall. Similarly, as capital was withdrawn from the production of complementary goods with depressed prices and invested in the production of complementary goods with sharply higher prices, the prices of the latter would come down. From year to year the rise in prices would outweigh the fall in prices, because of the overall reduction in supply. At the same time, however, numerous cases would always exist in which prices fell.
On the basis of this discussion, it should be clear that if not accompanied by an increasing aggregate demand, a reduction in supply would be accompanied by widespread declines in individual prices, even while the weighted average of prices rose. It would therefore not qualify as a cause of what most people have in mind when they complain of inflation. In order for practically every price to rise, there must be rising aggregate demand. That is the only way that the demand for some goods can increase without reducing the demand for other goods.
vi. Falling Supply Is Incompatible With the
Debtor/Creditor Effects Associated With Inflation
Increases in the price level caused by supply reductions do not produce the effects on the relations between debtors and creditors that people associate with inflation. One of the major symptoms associated with inflation is that debtors gain at the expense of creditors. The debtors pay a contractually fixed rate of interest and are obliged to repay only a contractually fixed amount of principal. In a period of inflation, the debtors meet these contractual obligations in money of less value than they borrowed, and enjoy a gain at the expense of their creditors. For at the same time that prices rise, and reduce the purchasing power of the contractually fixed incomes and assets of creditors, the incomes and assets of debtors are free to rise without limit and generally do rise at a rate more rapid than prices. Thus debtors are enriched at the expense of creditors. The leading instance of this kind, of course, is that of stockholders—whose enterprises constitute a major category of debtor—being enriched at the expense of bondholders, a major category of creditor.
Now this phenomenon of debtors gaining at the expense of creditors, of stockholders gaining at the expense of bondholders, can occur only if the rise in prices results from an increase in the quantity of money and volume of spending—that is, from an increase in aggregate demand. It cannot occur if the rise in prices results from a decrease in the supply of goods. It follows that if the debtor/creditor effects just described are to be regarded as an essential feature of inflation, inflation must be a phenomenon fundamentally of increases in money and spending, not decreases in production and supply.
Totally unlike the situation which prevails under inflation, the fact is that when prices rise because of falling production and supply, debtors do not gain at the expense of creditors. This can be clearly shown on the basis of Figure 19–1, titled “Falling Production and Supply Under an Invariable Money.” Figure 19–1 is the virtual mirror image of Figure 17–1, which dealt with the effects of rising production and supply under an invariable money. 3 It provides the conditions for a virtual laboratory test of the effects of rising prices caused by falling production and supply on the relations between debtors and creditors, and will serve to demonstrate that in such conditions debtors do not gain at the expense of creditors.
In Figure 19–1, as in Figure 17–1, it is assumed that an existing 1K of capital goods, when used in conjunction with 1L of labor, makes it possible to produce either 2K of capital goods and 0C of consumers’ goods, at one extreme, or 0K of capital goods and 2C of consumers’ goods, at the other extreme, and that as the supply of capital goods changes, the overall ability to produce changes in direct proportion—e.g., doubling if the supply of capital goods should double, halving if the supply of capital goods should halve. Also, as in Figure 17–1, the simplifying assumption is made that all the capital goods in existence in any given year are productively consumed in that same year. Thus, as in Figure 17–1, it is necessary that the economic system devote half of its productive efforts to the production of capital goods if it is to maintain the existing supply of capital goods. The proportion of its productive efforts which it actually does devote to the production of capital goods is, of course, determined by the demand for capital goods relative to the demand for consumers’ goods.
As in Figure 17–1, the initial situation, depicted in Year 1, is that the demands for capital goods and consumers’ goods have been at the necessary 50 ⁄ 50 ratio, with 500 monetary units being spent for each, every year. Finally, as in Figure 17–1, the demand for labor is assumed to be constant at 300 monetary units per year. It is on the basis of the application of these assumptions concerning the demands for capital goods and labor to Year 0, which is not described in the figure, that the cost values of the capital goods and consumers’ goods available at the start of Year 1, namely, 400 and 400, are derived. They are each 50 percent of 800, which is the sum of the 500 of demand for capital goods plus the 300 of demand for labor that took place in Year 0.
Figure 19–1, as I have said, is the virtual mirror image
of Figure 17–1. Thus, instead of net consumption falling from 200 to 100, as it did in Figure 17–1, it rises from 200 to 300, with the result that the demand for capital goods, instead of rising from 500 to 600, now falls from 500 to 400, while the demand for consumers’ goods, instead of falling from 500 to 400, rises from 500 to 600. Thus, the relative demands for capital goods and consumers’ goods change from 500 ⁄ 500 to 400 ⁄ 600 rather than to 600 ⁄ 400 , which last was the case in Figure 17–1.
The effect of this change in the relative demands for capital goods and consumers’ goods is that starting with the production phase of Year 1, in which the changed relative demands of Year 2 are anticipated and production adjusted accordingly, the economic system now devotes only 40 percent of its productive efforts to the production of capital goods, and 60 percent to the production of consumers’ goods. The effect of this in turn is that the economic system becomes unable to produce a quantity of capital goods sufficient to offset the quantity of capital goods being used up in production. Thus while 1K of capital goods are productively consumed in Year 1, only .8K of capital goods are produced for the start of Year 2, along with 1.2C of consumers’ goods. In Year 2, which is the second year of the changed relative production of capital goods and consumers’ goods, the overall ability to produce is reduced, because of the reduced supply of capital goods available at the start of the year. The ability to produce in Year 2, instead of being describable by the limits of 2K of capital goods and 0C of consumers’ goods at one extreme, and 0K of capital goods and 2C of consumers’ goods at the other extreme, is now 20 percent less, that is, describable by the narrower limits of 1.6K of capital goods and 0C of consumers’ goods at one extreme, and 0K of capital goods and 1.6C of consumers’ goods at the other extreme. This is because production takes place on the foundation of a supply of capital goods only 80 percent as large, namely, .8K of capital goods instead of 1K of capital goods, and can therefore itself be only 80 percent as large.
The continuation of the 40 ⁄ 60 ratio of the production of capital goods relative to the production of consumers’ goods results in a supply of capital goods at the start of Year 3 of .64K (i.e., .4 x the limiting extreme of 1.6K), and in a supply of consumers’ goods of .96C (i.e., .6 x the limiting extreme of 1.6C). Thereafter, as the result of a process of less capital goods causing less productive ability, resulting in still less capital goods, and so on and on, in every year the supply both of capital goods and consumers’ goods goes on falling—in the specific conditions of our simplified example, by exactly 20 percent per year.
Now although not explicitly shown in Figure 19–1, it follows inescapably, precisely because of the 20 percent annual fall in supply in the face of a fixed aggregate demand, that the general price level both of consumers’ goods and of capital goods rises at an annual rate of 25 percent from Year 3 on. For example, in Year 3, 600 of demand for consumers’ goods buys a supply of consumers’ goods of only .96C, while in Year 2 it bought 1.2C of consumers’ goods. This represents a 20 percent reduction in the supply purchased for the same money. In Year 4, the same-sized aggregate demand for consumers’ goods buys only .768C of consumers’ goods—that is, a supply reduced once more by 20 percent. Our knowledge of the pricelevel formula implies that where demand is fixed and supply is four-fifths as great, prices must be five-fourths as great, that is, 25 percent higher. And so it will be in every year beyond Year 4.
What is also the case in Figure 19–1 is that at no time is there an increase in the aggregate value of business assets. In Years 1 and 2, the opening assets of business are 1,800 monetary units. And in Year 3 and every year thereafter, the opening assets of business are 1,700 monetary units, reflecting the rise in net consumption to 300 monetary units and fall in productive expenditure to 700 monetary units, which took place in Year 2 and is maintained in every year thereafter.
Now the total value of business assets represents the sum of the equity and debt capitals invested in business, that is, the sum of the capitals invested by stockholders, partners, and proprietors, on the one side, and the sum of the capitals invested by bondholders and other creditors of business, on the other. The fact that nominal capital in the aggregate is fixed, or at least cannot increase (it did undergo a decrease), means that there is a loss as the result of rising prices caused by falling production and supply, not merely to bondholders and other creditors of business, but to the owners of capital as such. This means, it is not only bondholders and the like, whose assets are contractually fixed in money, who lose when production falls and prices rise, but the average capitalist as such—the average capitalist irrespective of whether he is a bondholder or a stockholder, that is, irrespective of whether he is a creditor-capitalist or a debtor-capitalist.
Indeed, if business had no debts whatever and there were only equity capital and thus every capitalist were in the position of being able to profit and add to his capital without any contractual limitations, the position of the average equity capitalist would be exactly the same as that of a bondholder. Some individual capitalists, to be sure, might gain. Not having their assets or incomes contractually fixed, they might earn extraordinary profits and accumulate nominal capital at a rate as fast or faster than the rate at which prices rose. But if the aggregate value of business assets and the average rate of profit is fixed, which are implications of a fixed quantity of
money together with a fixed rate of net consumption and a given array of marginal productivities of capital, then for every individual capitalist who earns a rate of profit above the average and who can add to his nominal capital, there are other individual capitalists who earn a rate of profit equivalently below the average and who equivalently consume their nominal capitals.
What stands out as clearly as possible in this case is that from the perspective of equity capitalists as a class, i.e., on the average, the effect of rising prices caused by falling production and supply is exactly the same as it is on creditor capitalists as a class. That is, on the average their capitals and incomes are fixed, and the rise in prices caused by the fall in production and supply reduces the purchasing power of their capitals and incomes, just as it reduces the purchasing power of the capitals and incomes of creditor capitalists.
It is not necessary to assume that business has no debts and that all capitalists are equity capitalists. This is because identically the same results follow if equity capital is any lesser proportion of the total capital invested in business firms. Thus, imagine that of the 1,700 monetary units of capital that is invested in business from Year 3 on in Figure 19–1, half represents the equity capital of stockholders and the like, and half represents the debt capital of bondholders and the like. Both halves of the capital will lose to the same extent as the result of rising prices caused by falling production and supply. The same would be true if the proportions of equity and debt capital were one-fourth and three-fourths, one-tenth and nine-tenths, or any other proportions. By the same token, whatever portion of the 300 of aggregate profit generated by the 300 of net consumption in Figure 19–1 represents profit after deduction of interest and whatever portion represents interest, the purchasing power of both portions would be reduced equally by any rise in prices resulting from falling production and supply.
Thus, what Figure 19–1 shows is that if all that happens is a fall in production and supply, then it is certainly true that prices rise and creditors suffer, because their contractually fixed money revenues and incomes buy less, as do their assets, which are also contractually fixed in money. But in that case, debtors suffer equally from the rise in prices.
If prices rise because of falling production and supply, the money revenues and incomes of debtors do not rise on the average any more than those of creditors, which is to say, not at all. Nor does the money value of the assets of debtors rise on the average any more than that of creditors, which again is to say, not at all.
If the rise in prices is due to a fall in production and supply, while conditions on the side of money and demand are unchanged, then the aggregate money revenues and incomes of the debtors are exactly what they were before the fall in supply and rise in prices. There is simply no possible basis of a rise in aggregate money revenues or incomes in the face of unchanged conditions of demand. This is because what unchanged conditions of demand mean is that the expenditures constituting sales revenues are the same and the productive expenditures giving rise to costs are the same. Thus aggregate sales revenues, aggregate costs, and aggregate profits are the same. In such circumstances, to whatever extent the average debtor sells at higher prices, he necessarily has correspondingly less to sell—precisely because the rise in prices is the result of less supply; indeed, as we know, in the conditions of a fixed aggregate demand, the rise in prices must be the result of an inversely proportionate reduction in supply. Thus, being able to earn no more money on average than he used to earn, the debtor’s difficulty in repaying his debts can be no less than it used to be. This is illustrated in Figure 19–1 by the fact that in every year in which business debtors sell at 25 percent higher prices, they have precisely 20 percent fewer goods to sell. In other words, they are in the position of selling at five-fourths the prices only four-fifths the quantity of goods, which means they take in only the same amount of money revenue. And with the stabilization of aggregate productive expenditure and thus costs, their money net incomes also become fixed. Indeed, having to repay the same debt out of the same revenue or income in the face of higher prices for what one buys, makes the repayment of debt more difficult than it was before, because of the reduction in one’s real disposable revenue or income. 4
Similarly, to whatever extent the price of the average debtor’s capital assets rises, because of a reduction in their supply, there is nothing present to increase the aggregate value of such assets or, therefore, the value of the capital assets in the possession of the average debtor. In the absence of an increase in the quantity of money and volume of spending, the rise in the average price of capital assets is merely in inverse proportion to the decline in their supply. Indeed, insofar as decreases in supply are the result of a lower economic degree of capitalism or lower degree of capital intensiveness in the economic system, the aggregate monetary value of the assets of debtors (and creditors) is less in the face of any given quantity of money and volume of spending of the kind that generates business sales revenues, because it reflects less saving and productive expenditure relative to any given amount of sales revenues. Precisely this, of course, is the situation in Figure 19–1, in which the aggregate capital invested in the economic system falls from 1,800 monetary units to 1,700 monetary units between Years 1 and 3.
Going still further, in the case of rising prices caused by falling supply, it is easy to imagine conditions in which individuals would be worse off as debtors than as creditors. Thus, for example, imagine a war, with massive bombing and shelling, which destroyed a major portion of the plant and equipment of every firm, but which was not accompanied by any change in the quantity of money or volume of spending in the economic system. In this case, production would be greatly reduced, and prices would correspondingly rise. Creditors would lose a corresponding portion of their buying power, because their money incomes and assets would be fixed. But debtors would lose even more of their buying power. This would be the case because not only would they too have to pay the higher prices, but also the money value of their assets would actually be sharply reduced, in that, as equity owners, they would suffer the full loss in the value of the assets of their firms before the creditors suffered any loss. The debtors—not only business debtors such as stockholders, but also owners of homes that were damaged and on which there were mortgages—would suffer the loss of a major portion of their monetary net worth at the same time that they faced the need to pay higher prices. 5
In the case of rising prices caused by falling supply, it is likely that debtors would actually experience conditions closer to those of deflation than inflation. By this, I mean that to some extent their revenues and incomes would actually fall for a time, precisely as the result of the fall in production and supply. To understand this phenomenon, recall that back in Chapter 13 I showed that in the case of goods with major accumulated stocks, such as housing and automobiles, in which the funds expended in the purchase of previously produced goods can far exceed the funds expended in the purchase of newly produced goods, the effect of increases in production would be to increase the size of the market for newly produced goods relative to the market for previously produced goods and thus to draw funds to the former from the latter. 6 In the present, opposite case of falling production, the size of the market for newly produced goods declines relative to the market for previously produced goods, whose accumulated stocks reflect the greater production of prior years. As a result, funds are now drawn to the market for previously produced goods and away from the market for newly produced goods. In this way, the demand for the goods and services of business firms, which, of course, are engaged overwhelmingly in new production, is correspondingly reduced.
Along the same lines, as a further irony, insofar as the effect of a reduction in production is a reduction in the production of commodity money, the result, as a minimum, is a reduction in the rate of increase in the quantity of money and volume of spending. Thus, the effect is a greater difficulty, compared to what it otherwise would have been, of earning any given sum of money and thereby repaying debt. Thus, in this way too, the effect of reductions in production and supply is directly contrary to the debtor/creditor effects associated with inflation, irrespective of any rise in prices that may result.
All of the foregoing leads to the conclusion that in
Figure 19–2
The Initial Balance Sheet of a Hypothetical Average Firm
Before a Rise in Prices Resulting from Any Cause
ASSETS
$2,000,000 representing a given quantity of plant, equipment, and inventories at a given level of prices and capable of producing a given physical volume of output at a corresponding level of prices.
LIABILITIES $1,000,000 of debt to bondholders and other creditors.
$1,000,000 net worth of stockholders. $2,000,000
order to account for the phenomenon of debtors gaining at the expense of creditors, the rise in prices must originate on the side of money and demand, not supply. There must be more aggregate demand, due to the increase in the quantity of money. This alone is what raises the sales revenues, money incomes, and property values of debtors as a class and thus makes debt repayment easier for them. In this case, the increase in their money incomes and money net worths can outstrip the rise in prices to the same extent as the fixed money incomes and asset values of the creditors fall behind the rise in prices.
The complete dependence of the debtor/creditor effects associated with inflation on the increase in the quantity of money and volume of spending in the economic system, can be illustrated in terms of a series of balance sheets for a hypothetical average business firm. These are shown in Figures 19–2, 19–3, and 19–4.
Figure 19–2 describes an initial state of affairs, in which the average business firm has total assets worth $2 million, $1 million of which represents capital supplied by bondholders—creditors—and $1 million of which represents capital supplied by stockholders—debtors. At the same time, the $2 million of assets reflect a given physical supply of capital goods, in the form of plant, equipment, and inventory, at a given average unit cost of capital goods. 7 This supply of capital goods is capable of producing a given volume of physical output. When the combined consumers’ goods output of all such firms in the economic system is divided into a given aggregate demand for consumers’ goods, the result is the initial general consumer price level.
Figure 19–3 shows an average balance sheet for conditions in which prices have doubled owing to a halving of supply. Here, because conditions on the side of money and demand remain the same, $2 million is still the monetary value of the assets of the average business firm, with the only difference being that now $2 million represents half the physical quantity of capital goods at twice the average unit cost of capital goods. In this case, the bondholders continue to have their million of capital and the stockholders continue to have their million of capital. Both classes of investors lose equally in terms of the buying power of their assets, which is cut in half because of the doubling of the price of consumers’ goods that results from the halving of the supply of capital goods and thus of the ability to produce consumers’ goods. 8
Only in the conditions of Figure 19–4, where the doubling of prices results from a doubling of the quantity of money and volume of spending, are the stockholder/debtors as a class in a position to gain as prices rise. Their gain results from the fact that the increase in the quantity of money and volume of spending increases the money revenue and income of the average firm at the same time that it raises prices. Because of the rise in its revenue and income, the average firm is enabled to increase its saving and reinvestment. The result is a rise in the total monetary value of the capital assets of the average firm. This increase, of course, accrues to the benefit of the stockholder/debtors, not to the benefit of the bondholder/creditors, whose incomes and assets are contractually fixed.
Figure 19–3
The Balance Sheet of a Hypothetical Average Firm Following a Rise in Prices
Caused by a Halving of Supply
ASSETS
$2,000,000 representing half of the initial quantity of plant, equipment, and inventories at double the initial level of prices and capable of producing half the physical volume of output at a doubled level of prices.
LIABILITIES $1,000,000 of debt to bondholders and other creditors.
$1,000,000 net worth of stockholders. $2,000,000
Thus, in Figure 19–4, the money value of the assets of the average firm has doubled from $2 million to $4 million. The capital of the bondholder/creditors is contractually fixed and therefore remains at $1 million. Accordingly, the $2 million increase in the value of the assets of the average firm accrues to the stockholder/debtors, whose capital thus rises from $1 million to $3 million. In these circumstances, as prices double, the bondholder/creditors, whose assets remain fixed, suffer a 50 percent loss in real wealth. The stockholder/debtors, on the other hand, whose nominal capital triples when prices double, obtain a 50 percent gain in real wealth. Exactly the same results apply to real income, inasmuch as the doubling of money and spending results in a doubling of profits gross of interest. With the amount of interest contractually fixed, the increase in gross profits accrues to the benefit of the stockholder/debtors. A doubling of prices thus represents a halving of the real incomes of the bondholder/creditors and an equivalent increase in the real incomes of the stockholder/debtors.
Of course, the stockholder/debtors will not be able permanently to gain in this way. The rise in the nominal rate of profit that is caused by the increase in the quantity of money and volume of spending sooner or later raises the nominal rate of interest correspondingly. From that point on, continued inflationary gains of the stockholder/debtors at the expense of the bondholder/creditors depend on a further acceleration of the inflation.
Before leaving the subject of debtor/creditor effects, it is important to bear in mind that in the absence of an increase in the quantity of money, any rise in the rate of profit inaugurated by a rise in the rate of net consumption, such as occurs in Years 2 and 3 of Figure 19–1, is accompanied by a reduction in the aggregate value of capital assets. 9 This is because the corollary of a higher rate of net consumption in such circumstances is an absolute decline in saving and productive expenditure, which serves to reduce the aggregate, accumulated value of capital assets. Thus, even if it were the case that alongside of rising prices resulting from falling production and supply, the rate of profit were temporarily to rise relative to contractually fixed interest rates that were geared to a preceding, lower rate of profit, and thereby give business borrowers a temporary advantage at the expense of their creditors, it would still not be proper to describe the situation as one of inflation. In such circumstances, precisely during the time in which the rate of profit was rising, both sets of capitalists would experience an actual decline in their nominal capitals. This, of course, is the exact opposite of what goes on under inflation, where the increase in the quantity of money and rise in the rate of profit and interest results not only in stockholder/debtors but also in bondholder/creditors adding to their nominal capitals. 10
Moreover, the very fact that the process is the result of a rise in the rate of net consumption and corresponding fall in saving operates to raise the rate of interest immediately. The rate of interest rises as the result of a reduction in the supply of savings, and thus of available
Figure 19–4
The Balance Sheet of a Hypothetical Average Firm Following a Rise in Prices Caused by a Doubling of Money and Demand
ASSETS
$4,000,000 representing the initial quantity of plant, equipment, and inventories at double the initial level of prices and capable of producing the initial physical volume of output at a doubled level of prices.
LIABILITIES $1,000,000 of debt to bondholders and other creditors.
$3,000,000 net worth of stockholders. $4,000,000
credit, in the face of the prevailing initial rate of profit. Indeed, it is probable that the rise in the rate of interest would actually precede the rise in the rate of profit, which would be delayed insofar as negative net investment took place. (Extensive negative net investment is not shown in Figure 19–1, because of the simplifying assumption that all capital goods in existence at the beginning of any year are used up in that same year. It would exist in reality, however.) Thus, in the case of a rise in the rate of profit caused by a rise in the rate of net consumption, there would be no sudden surge in the rate of profit in the face of a large volume of contractually fixed interest rates geared to a substantially lower rate of profit, which, of course, is what occurs in a period of inflation. This conclusion is reinforced by the fact that the rise in the rate of net consumption would itself almost certainly be slow and gradual rather than sudden and precipitous. Indeed, the very fact that in the absence of an increase in the quantity of money and volume of spending in the economic system, a rise in the rate of net consumption entails a fall in saving and productive expenditure, resulting in negative net investment and capital decumulation, and correspondingly reduces the availability of credit, gives the situation much of the character of a period of deflation and financial contraction, despite the existence of rising prices. 11
On the basis of all of the preceding, it should be clear that the debtor/creditor effects associated with inflation can take place only on the foundation of an increase in the quantity of money and volume of spending. A rise in prices resulting from a decrease in production and supply would simply not be accompanied by such effects. Thus, if debtors gaining at the expense of creditors is to be regarded as an essential symptom of inflation, it follows that inflation is a matter of increases in money and spending, not decreases in production and supply.
vii. Falling Supply as a Cause of Inflation Implies That Rising Supply Is a Cause of Deflation and Depression
Finally, there is still one more reason for excluding higher prices caused by less supply from the category of inflation. And that is that if they are described as inflation, it implies the absurdity that more supply—more wealth—is the cause of depressions and poverty. Because if higher prices due to less supply are inflation, then it follows that lower prices due to more supply are deflation. But deflation is virtually synonymous with a depression, which is a state of poverty. Thus, if we say that higher prices due to less supply are inflation, we imply that more supply causes deflation, depression, poverty. This is a self-contradiction, no less absurd than such 1984 notions as “war is peace” and “freedom is slavery,” because more supply means more goods, which, of course, means greater prosperity. 12 Thus, in addition to all of the other reasons I have given, we should avoid describing rising prices caused by falling supply as inflation, in order to avoid being guilty of this contradiction.
The truth is that both inflation and deflation are concepts that do not pertain to changes in the price level per se, but, at most, only to changes in the price level that originate on the side of money and demand. 13
We have now eliminated reductions in supply as a cause of “inflation.” We have eliminated them, first of all, as a significant factor in raising prices (points i–iii) and have shown that to an important extent reductions in supply are themselves the result of rapid increases in aggregate demand (point iv). And, to the extent we have not totally eliminated reductions in supply as a factor in raising prices, we have shown that such price increases as they do cause cannot properly be described as inflation. They cannot, because they contradict important symptoms of inflation (points v and vi), and because to describe them as inflation implies the absurdity that wealth is the cause of poverty (point vii).
This means that we have narrowed the problem of inflation down exclusively to one of rising aggregate demand, which our formula for the general consumer price level shows to be the only conceivable remaining explanation. Thus, we are now in a position to show why all of the explanations of an inflationary rise in prices other than the quantity theory of money are either totally false or must be interpreted as giving further confirmation of the quantity theory of money.
2. Refutation of the “Cost-Push” Doctrine in General
The supporters of the cost-push doctrines recognize the validity of the formula for the general consumer price level. However, they perceive the role of rising demand in a different way than do the supporters of the quantity theory of money. While the supporters of the quantity theory of money see more demand as the cause of higher prices, the supporters of the cost-push doctrines see it as the cause of greater production and supply. In their view, more demand causes correspondingly more production and supply and therefore does not raise prices. The reason the supporters of the cost-push doctrines believe this is because they see the existence of unemployed labor and idle plant capacity, and they assume that so long as unemployment and idle capacity exist, the effect of more demand is simply to enable more people to be employed and therefore for production to be increased.
The supporters of the cost-push doctrines are willing to concede that more demand is potentially capable of
raising prices. But that, they say, could happen only in the context of an economy operating at full employment and in which, therefore, supply could not be further increased in response to more demand. At that point, they are willing to admit, more demand would not be accompanied by more supply and would thus drive up prices. The expression they use to describe this situation of more demand raising prices at the point of full employment is, of course, “demand-pull inflation.” At the point of full employment, they say, more demand “pulls up” prices. This socalled demand-pull inflation is the only potential influence of more demand on prices that they recognize. To them, more demand as a cause of inflation means “demand-pull inflation.” 14
Observe how the supporters of the cost-push doctrines think. They have decided that more demand is capable of raising prices only at the point of full employment. They have decided that short of full employment, the effect of more demand is not higher prices, but more supply. These are the assumptions they bring with them when they observe that since World War II our economic system has not operated at full employment. As a result, they then conclude that they are free to dismiss rising demand as the cause of rising prices in the United States, because—as explained—they have already relegated more demand as a possible cause of rising prices to the arbitrarily limited context of full employment.
It is on this basis that they turn to the various forms of the cost-push doctrine as an explanation of the rising prices experienced since World War II. In their eyes, more demand cannot explain these price increases, because they occurred in the absence of full employment. Thus, some other explanation must be found. The reason rising costs are taken as the explanation is because, in fact, the prices of many goods are determined in the first instance on the basis of their cost of production, as I showed in Chapter 6 of this book. 15
Of course, I also showed that all prices determined by cost of production are ultimately determined by supply and demand, so there is no contradiction involved in my conceding the role of cost of production in determining prices and, simultaneously, arguing that all prices are determined by supply and demand. Cost of production— and this point is relevant now—is always based on prices, including wages, which are the price of labor. For example, the cost of producing a bicycle is based on the wages of the bicycle workers, the price of the steel that goes into the bicycle, and so on. It follows that cost of production can never be an ultimate explanation of prices, but just an intermediary explanation of some prices on the basis of other prices—for example, an explanation of the price of the bicycle on the basis of the prices of the labor and steel and so forth that are used to produce it. 16
The fact that cost of production is not an ultimate explanation of prices constitutes a major logical deficiency of the cost-push doctrine. Because what the cost-push doctrine is actually claiming is that some prices rise because other prices rise, and it is content to leave matters at that. For example, the supporters of the cost-push doctrine blame inflation on such things as the rise in the price of steel or the rise in wages achieved by various unions. They do not offer any explanation of what makes possible the higher price of steel or the higher wages obtained by the unions.
In fact, as already shown, what the cost-push doctrine boils down to is the claim that certain key prices, and this includes wages, rise arbitrarily, without any explanation other than the greed of those who raise them. The cost-push doctrine, in the last analysis, is a doctrine that tries to blame price increases on some form of arbitrary power. It tells us, in effect, that prices rise simply because some powerful people are making them rise.
Now it is true that in our present economic system, that is heavily overlaid with government regulations and controls—i.e., the socalled mixed economy—arbitrary power does exist. There are labor-union monopolies in a position to force employers to agree to almost any wages they ask. There are also some business monopolies, such as government-franchised electric utilities (though the business monopolies are generally regulated in the prices they can charge).
Nevertheless, even the existence of arbitrary power on the part of sellers cannot explain rising prices. I will explain this more fully in the specific discussions of the wage-push and profit-push doctrines that follow. But this much can be said right now: The basic reason why arbitrary power on the part of sellers is not a sufficient explanation of rising prices is that such higher prices as it might bring about always cause reductions in the quantity of the good or service that can be sold and, therefore, act as a brake on any further such price increases. This is closely related to an even more fundamental objection, namely, that the cost-push doctrines are equivalent to an attempt to blame inflation on falling supply, which we have already seen is invalid.
In order to prove this equivalence, all that is necessary is to perform a kind of mental experiment in terms of the pricelevel formula
P = D C .
S C
Our mental experiment consists simply of this: We assume that monopolistic sellers arbitrarily drive up prices, just as the cost-push doctrine claims. But we also assume that while this rise in prices occurs, there is no change in aggregate demand. We make this second assumption
because if the rise in aggregate demand is really not a factor in raising prices, as the supporters of the cost-push doctrine tell us, then its absence can make no difference.
Thus, what we have is a rise in prices and a fixed aggregate demand—a fixed amount of spending. In terms of the elements of our formula P is up, while D C is fixed.
Nothing could be more obvious than the result of this experiment. Namely, S C must fall in inverse proportion to the rise in P. The higher the monopolistic sellers would drive the price level, the less would be the supply of goods they could sell—in inverse proportion.
Let us appraise the results of this experiment. We see the quantity of goods sold falling to the same extent that the monopolistic sellers force up prices. There is no essential difference between this case and the cases discussed previously in which a fall in supply raised prices— they are mathematically equivalent. A fall in supply is a mathematically indispensable condition for the rise in prices, whenever demand remains fixed. Thus, it is absolutely essential for the monopolistic sellers to reduce the supply of goods or services that are sold, if they are to drive up prices. If they did not do this, they simply could not raise prices. It is precisely because the monopolistic sellers must hold down supply to raise prices, that they want to prohibit other people from selling and to be monopolists in the first place. For example, the reason a monopoly labor union wants to control apprenticeship programs and make it as difficult as possible for people to enter an occupation is that that is a way of restricting supply and thereby making it possible for the union to drive up wages. In the face of a fixed demand, the mere fact of establishing higher wages or prices for the labor or goods that are sold serves to reduce the supply that is sold in inverse proportion. The unions and the other monopolists want to restrict as far as possible the supply that is or potentially could be offered by competitors, in order to minimize the reduction in the quantity that they themselves can sell.
The fact that the various cost-push doctrines are the same as an attempt to blame inflation on falling supply totally invalidates them. Because it means that all of the objections raised previously against falling supply as a cause of rising prices apply with equal force against cost-push as a cause of rising prices.
It is now possible to deal with each of the specific versions of the cost-push doctrine, in the light of the knowledge of what the doctrine in general implies about supply.
3. Critique of the “Wage-Push” Variant
The wage-push argument is the most plausible version of the cost-push doctrine, because what it really refers to are the activities of legally privileged, government-protected labor unions. Such labor unions possess monopoly powers in that employers are compelled by law to deal with them and either to meet their wage demands or do without labor; in addition, these unions are often in a position to resort to direct intimidation and violence to back up their demands, without fear of legal reprisal. Because of these monopoly powers, the unions are able to set wages as high as they like. Even nonunion employers must adopt the pay scales set by the unions, lest their workers decide to unionize, which they can easily do. In this way, the unions are able to drive up wage rates, costs of production, and thus prices, throughout the entire economic system.
Nevertheless, as destructive as this power of the present-day unions is and as serious as its consequences are, if this were the only factor at work—if it were not joined by an expanding quantity of money and a rising aggregate demand—it would not be possible for the unions to exert any longrun or significant influence in making prices rise. In fact, on a longrun basis, prices would probably fall in an economy such as ours, despite the activities of the unions. The fact is that it is only an expanding quantity of money and a rising aggregate demand that permit socalled “wage push,” or any other form of “cost push,” to go on “pushing” very far.
The reasons are as follows. If demand—spending— did not rise, if it stayed the same, any increase in the general price level brought about by “wage push” would be accompanied by a corresponding decline in the supply of goods that could be sold, as we just saw in our mental experiment concerning the effects of cost push. This decline in the quantity of goods that could be sold at higher prices would cause a corresponding reduction in the quantity of labor that employers could profitably employ. Because if the quantity of goods employers can sell falls, they obviously require less labor for production. The same conclusion follows even more directly from the effects of higher wage rates in the face of a limited aggregate demand for labor, i.e., limited total payrolls in the economy. Because the total funds available for meeting payrolls are limited, employers simply do not have the financial means of employing as many workers at higher wage rates as they do at lower wage rates.
Now this mounting reduction in the volume of employment offered every time wages and prices were increased would place a limit on the extent to which the unions would drive up wages and prices. Socalled wage-push inflation would burn itself out in mounting unemployment. Every time a union sought a wage increase, it would have to count the number of its members it was prepared to see added to the ranks of the unemployed. The point would soon be reached where the sheer volume
910 CAPITALISM of their own unemployed members would stop further wage demands even on the part of the worst monopoly labor unions.
In order to appreciate just how limited would be the power of monopoly unions to raise prices without the aid of a rising aggregate demand, let us perform another mental experiment. Let us imagine that we have full employment and that aggregate demand is fixed. Now let us trace the consequences of the unions driving up the wage and price level by varying amounts. Each time they raise wages and prices, the quantity of goods that can be sold falls, the quantity of labor required in production falls, and the unemployment rate grows. The question we want to ask is: If the unions were willing to drive the unemployment rate to the height that prevailed in the worst years of the 1929 Depression before stopping in their wage demands, how much could they raise prices?
The unemployment rate in 1932 and 1933 was about 25 percent of the labor force. If it took that kind of staggering unemployment rate to stop the further demands of the unions, it would be implied that the maximum cumulative limit by which the unions could raise wages and prices would be one-third, and no more. That degree of wage and price increase would produce a 25 percent unemployment rate.
These conclusions follow mathematically, on the basis of the pricelevel formula. A 25 percent unemployment rate leaves a 75 percent, positive employment rate, i.e., the number of workers employed is reduced to three-fourths of the initial number. In these conditions, production and supply can be presumed also to fall to three-fourths of their initial level. (If the operation of the law of diminishing returns is allowed for, production and supply would not fall this much: the loss of the last one-fourth of the labor employed would reduce production by less than one-fourth.) The pricelevel formula, of course, shows that if supply is three-fourths, while demand is fixed, prices must be four-thirds:
4 P = D C .
3 3
4 S C
Prices of four-thirds mean a rise in prices of one-third. Hence, the movement from a zero unemployment rate to a 25 percent unemployment rate would be accompanied by a rise in the price level on the order of one-third. Or, conversely, starting from full employment, driving up wages and prices by one-third would produce an unemployment rate of 25 percent.
This rise in prices and unemployment might take place all at once, or it might occur gradually over many years, depending on how rapidly or slowly the unions forced up wage rates. But whether it occurred rapidly or slowly, one-third or some amount not much greater than a third, and probably quite a bit less, would be the maximum cumulative limit of a rise in prices ascribable to monopoly labor unions. Because the fact is that the ability of the monopoly unions to raise wages and prices is severely limited by the effect of such wage and price increases on the unemployment rate, and it can be safely assumed that even the monopoly unions would be deterred from further wage demands in the face of an unemployment rate at the level of a catastrophic depression. Indeed, the experience of the early 1980s showed that the unions were willing sharply to reduce their wage demands in the face of an unemployment of 10 or 11 percent and even to accept wage reductions in a number of cases.
Moreover, once the unions decided to stop their demands, and the unemployment rate stabilized, at however high a level, prices would probably actually fall.
The fall in prices would occur as the result of technological progress and capital accumulation, or any other factor that increased the productivity of labor—that is, which enabled a unit of labor, on average, to produce more. Increases in the productivity of labor, of course, mean that larger supplies of goods are produced by the same number of workers and that each unit of goods has a lower cost of production, because it takes less labor to produce it. A rise in the productivity of labor acts to reduce prices, because it means both larger supplies and lower unit costs. It is an offset to “wage-push.”
To illustrate this point, let us assume that after the unions had raised the wage and price level by the limit of a third, the productivity of labor began to increase, as the result of the application to production of a series of inventions. Assume that over a period of years the cumulative effect of these inventions was to double the productivity of labor. In that case, the three-fourths of the labor force that was employed would produce twice as much as it previously did. Prices, therefore, would fall by half in comparison with the point to which the unions had raised them. And that would mean that they would actually be lower than they were before the unions began their activities. They would be half of four-thirds, i.e., only two-thirds of their initial height. In terms of our formula,
1 × 4 P = D C .
2 3 3
2 × 4 S C
To the extent that increases in the productivity of labor occurred at the same time that the unions were driving up wage rates and creating unemployment, their effect would be to offset the rise in costs and decline in production attributable to the unions. It might very well be the
case, therefore, that the unions alone would not be able to raise the price level even temporarily.
On the basis of these considerations, we must conclude that it would simply be impossible for monopoly labor unions, unaided by increases in the quantity of money and rising aggregate demand, to make any sustained significant contribution toward raising the general price level. Indeed, in the absence of an expanding money supply and rising aggregate demand, the longrun effect of the unions on the price level, and probably the short-run effect too, would most likely be not to raise it in any absolute sense, but merely to reduce the rate at which it had fallen.
Unaided monopoly unionism, or “wage push,” is not the cause of rising prices but of mass unemployment. As I have shown, the rise in prices it might bring about would be essentially nonrepeatable, would probably be temporary at most, could never be of really major significance as price increases go, and could easily be far more than offset by increases in the productivity of labor, with the result that prices actually fell, though by less than they otherwise would have. But the unemployment monopoly unionism creates remains, and is of major significance.
The problem of unemployment leads us to the real connection between monopoly unionism and rising prices. Because what the government does when confronted with the prospect of rising unemployment is to inject a larger quantity of money into the economic system. The additional demand that results permits the unions to drive up wages and prices without causing corresponding additional unemployment.
The fact that the quantity of money and demand are made to increase more or less in pace with the wage demands of the unions is the only thing which permits the phenomenon of “wage push” to continue in existence, because it removes the brake that would otherwise be supplied by a mounting rate of unemployment. In other words, it is the government’s expansion of the money supply that is the only thing that allows the unions to go on “pushing” wage rates and prices up very far. To put it in still a different way, no more “wage-push inflation” exists than the government is willing to provide an expanding quantity of money to finance.
The government and the economists who support it chronically evade the very necessary, critical role of the expansion of the money supply. As they describe matters, the unions simply drive up wages and prices without limit, and the government has nothing whatever to do with the mater. Its role is merely to urge the unions to exercise “restraint.”
The fact is that the government’s expansion of the money supply and thus of aggregate demand positively encourages the wage demands of the unions, and does so even in the midst of mass unemployment. As we have seen, it calls union wage demands into being when they would otherwise not have existed—by removing the brake on wage demands constituted by the prospect of adding further to the already existing level of unemployment; by enlarging nominal profits, which constitutes a veritable red flag to the unions and their demands for wage increases; and by causing prices of goods available only in limited quantity to rise, which, together with rising prices caused by the unions’ previous wage demands, leads the unions to demand wage increases to keep pace with price increases. 17 And then, of course, the government’s expansion of the money supply and aggregate demand enables the unions to go on endlessly repeating the imposition of their demands, by removing the consequence of mounting unemployment.
Thus, the government’s expansion of the money supply must be regarded as the cause of the far greater part of “wage push”—as the cause of all of wage push insofar as the phenomenon is continuing and can be associated with a problem of inflation. To whatever extent there is an element of truth in the existence of “wage push,” the phenomenon must be regarded as an extension of the influence of the quantity of money, whose increase operates not merely through “demand pull,” but no less by means of making possible and, indeed, positively instigating wage push. In effect, the intellectual zone of explanation of rising prices previously regarded as belonging to the wage-push doctrine should henceforth be regarded as having been annexed by the quantity theory of money.
4. Critique of the “Profit-Push” Variant
According to the “profit-push” doctrine, prices rise primarily not because wages are rising but in order to increase the profits of “powerful monopolists” and “greedy big businessmen.” It is the push for ever higher profits, say the supporters of this doctrine, that initiates the socalled wage-price spiral, because the unions, it is alleged, demand wage increases only to keep pace with price increases and the cost of living.
Needless to say, the profit-push doctrine is enormously popular with the monopoly labor unions and their numerous supporters. All things considered, it is probably by far the most popular explanation of inflation, because, as we have seen, it is directly implied by the definition of inflation as rising prices.
Now, in fact, the profit-push doctrine is subject to all the essential criticisms made of the wage-push doctrine, plus some others. It ignores the fact that in the absence of rising demand, rising prices reduce sales volume—
912 CAPITALISM that is, they reduce the quantity of goods that can be sold. The prospective loss of sales volume makes even a government-protected monopolist limit his price at some point.
Indeed, let us consider precisely the case of a government-protected monopolist, because that case provides the most plausible context for the profit-push doctrine. Yet it is very easy to show that the doctrine cannot apply even there. And if it cannot apply there, it obviously cannot apply to any case in which the freedom of competition exists.
Thus, let us imagine a government-franchised electric utility that has been given the exclusive legal privilege of selling electricity in a given geographical area. Such a utility is protected from competition by law. Let us imagine further that the rates charged by this utility are not subject to any form of government regulation—it can legally charge any rate it likes. Nevertheless, even such a utility would still be limited in what it could charge by the forces of the market. It would not want to charge rates so high as to discourage large numbers of business firms from locating or remaining in its area. It would not want to charge rates so high as to discourage large numbers of homeowners from using electric heat or buying electrical appliances. Clearly, there would be a limit to what such a utility would charge, given the conditions of demand confronting it.
Now the prices charged by this uncontrolled monopoly utility might be considerably higher than the prices that would be charged under the freedom of competition or under government rate control. But what it is crucial to realize is that there is absolutely no reason why the utility would want to go on raising its price year after year. Such a monopoly could find it profitable to charge a very high price perhaps, but not a steadily rising price. Its interest would lie in picking the price that maximized its profits, and then sticking to that price. Given the same conditions of demand confronting it in the present as in the past, the monopoly would not raise its price in any given year for the same reason that it did not already charge that price in the year before—namely, it would lose too much business by doing so.
In order for the monopoly to find it to its interest to raise its price every year, the conditions of demand confronting it must be changing. People must have a growing ability to pay for its products. But how do people obtain that ability? One way might be if the prices of other things they bought were falling. This would release funds they previously required for other purposes. But observe. In this case, the rise in utility rates presupposes a fall in other prices and is strictly limited by the extent of their fall. This case, therefore, cannot be a case of a rise in the general price level. In this case, therefore, the problem of inflation does not even come up, but just a rise in some prices accompanied by a fall in other prices.
Another way people might be able to afford to spend more for electricity would be if they simply increased their relative valuation of electricity in comparison with goods they were previously buying. They might just decide, in other words, that they wanted to spend more for electricity and less for other things. But consider. This case means that the rise in demand for electricity is accompanied by an equivalent drop in the demand for other things. The effect of the drop in demand for other things is either to reduce the prices of other things or the supply of other things that is sold. In either event, the problem of inflation again does not come up—because we either have no rise in the general price level or one that can only be associated with a decrease in supply.
In order for the utility’s rate increase to be connected with a problem of inflation, its customers must be in a position to enlarge their spending for electricity without having to reduce their spending for other things. But this means they must be in a position to make a larger aggregate demand. Consequently, the only possible explanation of how even protected legal monopolists could raise their prices in a way that is relevant to the problem of inflation is that of a growing aggregate demand. And this, of course, in turn depends on an increasing quantity of money.
It must be stressed that with the exception of the cases in which the government violates the freedom of competition, it is a total reversal of things to regard the quest for higher profits as a cause of higher prices. As we have seen, where the legal freedom of competition exists— that is, where the government does not stand in the way of men competing—the quest for higher profits is always the cause of more supply and lower prices. This is because, as I demonstrated in Chapter 6, under the freedom of competition firms can earn higher profits only by introducing new and improved products, by finding ways to cut the costs of production, and by keeping the relative production of the various goods properly adjusted to the changing needs and wants of the consumers. As I showed, all of this represents an expansion in production and, therefore, a tendency toward a lower price level. It was nothing but the quest for higher profits that developed all of our industries and built our entire economic system over the last two hundred years. The effect of this has certainly been to make prices vastly lower than they would otherwise have been, because it has radically increased supply. Thus, the profit motive is, in fact, the source of lower prices, not higher prices. This conclusion is further strengthened if we look at what is done with most large profits after they are earned. Most such profits
are saved and invested. This, in turn, means more factories, more machines, more stocks of materials. And that means a greater ability to produce and, therefore, a larger supply of goods offered for sale and, consequently, again a tendency toward lower prices, not higher prices.
As I have already shown, the fall in prices that the profit motive has actually achieved is obscured by the fact that prices are expressed in terms of paper money, whose own value falls more rapidly than the profit motive can reduce the prices of goods. This is what is responsible for the rise in prices expressed in terms of paper money. 18 The situation is comparable to selecting a melting ice cube as a unit of volume and then observing that all measurements of volume persistently increase.
What complicates matters and makes the profit-push doctrine appear plausible to many people is that there is a definite association between inflation and a high rate of profit. However, it is not, as most people seem to believe, a rising rate of profit that raises the price level, but an expanding quantity of money and growing aggregate demand that increases both the price level and the rate of profit. As I showed in Chapter 16, rising aggregate demand raises the nominal rate of profit. Insofar as the rise in aggregate demand outstrips the rise in production and supply, the rise in the nominal rate of profit is accompanied by a rise in prices. It cannot be stressed too strongly that the rate of profit that is increased is not a genuine rate of gain, but merely the rate of profit as expressed in a depreciating paper money—that is, it is merely the nominal rate of profit that is raised, not the real rate of profit. The real rate of profit, of course, is the rate that is found after deducting from profits an allowance to cover the loss in the purchasing power of money. Indeed, in a period of inflation the real rate of profit typically falls.
We have already seen an excellent illustration of this fact in our discussion of the widespread ignorance and evasions that support price controls, namely, in the case of the hypothetical merchant who buys his goods at the beginning of the year and sells them at the end. We saw how inflation serves to raise the nominal rate of profit of this merchant while simultaneously reducing his aftertax real rate of profit. 19 As I will show later in this chapter, exactly the same situation applies in the case of depreciable assets, such as buildings and machinery. 20 Nevertheless, despite the decline in real profits it entails, despite the fact that it is an effect, not a cause of inflation, many people, particularly in politics and in the news media, never tire of blaming rising prices on the rise in the nominal rate of profit and implicitly or explicitly demand that government controls be imposed to limit profits.
5. Critique of the “Crisis-Push” Variant
The “crisis-push” doctrine is the attempt to blame rising prices on some sudden event, such as the Russian wheat deal in 1972, the Arab oil embargo in 1973, or the Iranian revolution in 1979, that reduces the supply and increases the price of some important good or group of goods. The doctrine rests on two basic errors. The first is the assumption that because a crisis can explain a large increase in the price of a particular good, it can explain a correspondingly large increase in the general price level.
A crisis can explain a dramatic increase in the price of the particular good in whose supply it takes place, if the good is a necessity. This is undisputed. For example, a few percent reduction in the supply of wheat or oil can cause a dramatic increase in the price of wheat or oil, as the Russian wheat deal, the Arab embargo/cartel, and the Iranian revolution all clearly showed. The inference drawn from this fact by the supporters of the crisis-push doctrine, however, was that these supply reductions could somehow also explain the less dramatic but nevertheless still very substantial rise in the general consumer price level that was taking place at the same time. That inference was an error.
It was an error because not only does a rise in the price of a necessity not explain a rise in the price of other items, but, as we have seen, it actually tends to make the prices of a whole host of other items fall. It has this effect because what makes it possible for people to pay the disproportionately higher price of the necessity undergoing the supply crisis is that they restrict their expenditure for other items. The prices of these other items, therefore, tend to drop. The result is that the overall rise in the general price level is relatively slight—because the dramatic rise in the price of the necessity suffering the supply crisis is largely offset in the average of prices by a mass of other prices that not only do not rise, but many of which actually fall. And because of the widespread declines in prices that would occur, even such rise in the general price level as a supply crisis could achieve would not qualify for description as a case of inflation, for the reasons already explained. 21
This reasoning applies not only to the case in which the good undergoing the supply crisis is a consumers’ good but also to the case in which the good undergoing the supply crisis is a capital good that itself enters into the production of a large number of other goods as a raw material. In the latter case, the rise in the good’s price does not serve equivalently to raise the cost of production and prices of its various products, as many people appear to believe. On the contrary, the rise in its price places pressure on the prices of other, complementary factors of
production to fall. A reduction in the supply of oil, for example, reduces the utility of such materials as iron, copper, rubber, and so on, and can even make them practically useless. It thus tends to reduce the prices of these raw materials. It also tends to reduce the wage rates of the workers required in the various processes of production that depend on oil. The result is that costs of production do not rise to the same extent as the price of oil, and where such other factors of production whose price has fallen enter into the production of products to a relatively greater extent than oil, costs of production actually tend to be reduced, not increased.
The second error of the crisis-push doctrine is that it confuses what is at most the cause of a transitory, delimited rise in the general price level with the cause of a permanent, repeated, and, indeed, accelerating rise in the general price level. By this, I mean that a crisis is capable of raising the general price level only in the period in which it reduces aggregate supply and only to the extent that it reduces aggregate supply. Thereafter, its ability to raise prices any further is exhausted. Furthermore, almost all supply-crises are subsequently solved. At that point, the effect of the restoration of supply should be to reduce the general price level to its former, precrisis level.
For example, the giveaway of a large part of our wheat to the Russians in 1972 could explain some rise in our price level in 1972 and 1973—a rise corresponding to the fall in aggregate supply that was constituted by the fall in the supply of wheat and wheat products. But in 1973 there was no repetition of the wheat deal. Therefore, insofar as it depended on the supply of wheat, by 1974 aggregate supply was restored to its precrisis level. And insofar as the supply of wheat was a factor determining the general price level, the general price level also should have been restored to its former, precrisis level.
It follows that if we want to explain why prices in 1974 were higher than in 1972, we cannot use such a thing as the crisis in the supply of wheat. The principle here is that all crises that end up being solved—and this includes the great majority of them—can be causes only of temporary increases in the price level.
To explain a permanent rise in the general price level on the basis of supply crises, one must assume that as one crisis is solved, another, of equivalent magnitude, erupts. But if one makes this assumption, one should realize that one cannot then use supply crises to explain a price level that rises from year to year. The effect of an annual repetition of more or less equal-sized crises that are later solved cannot be to raise the price level year after year, because the effect of each new crisis on the price level is canceled by the solution of an old crisis. Consequently, the most that could be explained would be a price level that was higher than it would be in the absence of crises, but not a rising price level.
In order to explain a rising price level on the basis of supply crises, one would have to find not only replacement crises for the ones that have been solved, but additional crises as well. And in the next year, one would have to find replacements for this larger number of crises, along with still more additional crises; and this would have to go on from year to year at a compound rate. In order to explain not merely a rising price level, but one that rises with acceleration, one would have to find not only supply crises growing at a compound rate, but growing at an accelerating compound rate. This, of course, would imply the rapid disappearance of material civilization.
In the years to come, because of growing irrationality on the part of the government, it is possible that we will have growing supply crises. But the most that these crises could be responsible for in the way of a rising price level would be on the order of one or two percent a year. Nevertheless, if they come to pass, prices will almost certainly rise far more rapidly—perhaps 50 or 100 percent a year, or more. That is because a major form in which the growing irrationality of the government will manifest itself, assuming it actually does occur, will undoubtedly be an accelerating expansion of the money supply.
The truth is that operating alongside the largely self-canceling phenomenon of the eruption of new crises and the solution of old crises is the expansion in the quantity of money and rise in aggregate demand. It is this which makes the price level rise far more rapidly than could ever be accounted for by an excess of new crises over the solution of old ones.
The root of both errors of the crisis-push doctrine is a failure to think on the conceptual level—a failure to go beyond what is immediately, almost perceptually evident. We have just seen that the second error rests on the failure to extend one’s field of observation back to the past and forward to the future—to see that the solution of yesterday’s crises should now be acting to reduce the price level—either actually to reduce it, or at least to nullify the ability of today’s crises to raise it; and that later on exactly the same point will apply to the solution of today’s crises; and thus that the real cause of steadily rising prices must be something other than the transitory and self-canceling element of crises.
The first error is very similar. It consists of the failure to extend one’s field of observation sideways, so to speak, to the goods whose supply is not in a state of crisis. This underlies the failure to see that supply crises act to reduce the demand for and the prices of all these other goods, and therefore could simply never account for a
very dramatic rise in the general price level, let alone for the phenomenon of almost universally rising prices, which people have in mind when they complain about “inflation.”
6. Critique of the Wage-Price-Spiral Variant
Little can be said in criticism of the wage-price spiral doctrine that has not already been said in criticism of the other variants of the cost-push doctrine. In the absence of an increase in the quantity of money and rising aggregate demand, any “wage-price spiral” that somehow came into existence would quickly burn itself out of existence in mounting unemployment and unsold stocks of goods. Even in cases in which labor unions hold the contractual right to receive wage increases on the basis of cost-of-living increases, they abandon this right when insistence upon it would add still more of their members to the ranks of an already large number of unemployed members. The experience of the early 1980s provides dramatic confirmation of the truth of these propositions.
7. Critique of the “Velocity” Doctrine
While the cost-push doctrines seek to deny the role of rising aggregate demand as the cause of rising prices, other doctrines opposed to the quantity theory of money concede the fact that more demand is responsible for rising prices. What they deny is that an expanding quantity of money is the cause of rising demand. They seek to blame something else for the growth in demand— something that will not leave a trail that runs back to government interference in the economic system.
The most important doctrine in this group is the velocity doctrine, which subsumes all of the other doctrines in the group. The velocity doctrine is the claim that the rise in aggregate demand that is admittedly responsible for the rise in prices is the result, not of an increase in the quantity of money, but of an increase in the velocity of circulation of money. The velocity doctrine has been widely taught at colleges and universities in a deliberate attempt to undercut the quantity theory of money.
To dispose of the velocity doctrine, nothing more is required than to recall the discussion of the demand for money in Chapter 12. There it was established that in the absence of increases in the quantity of money, any rise in velocity resulting from such factors as growing security of property and the development of financial markets and financial institutions would be the accompaniment of a process that increases both the complexity of production, in terms of the number of distinct stages requiring purchases and sales, and the physical ability to produce. 22 Both of these factors militate against any loss in the purchasing power of the monetary unit. The first, it should be realized, militates against a rise in the aggregate demand for consumers’ goods taking place as the result of the fall in demand for money, and thus against a rise in the socalled income velocity of money. It implies that the rise in spending takes place primarily or entirely in the purchase of labor services, capital goods, and securities, and thus that the rise in velocity occurs primarily or entirely in broader measures of velocity, above all, in socalled transactions velocity, which is the ratio of spending of all kinds to the quantity of money.
What causes an increase in velocity capable of substantially contributing to an increase in the demand for consumers’ goods and to a rise in prices is precisely the increase in the quantity of money. As shown, the more rapidly the quantity of money increases, the less tends to be the demand for money for holding and thus the higher tends to be the velocity of circulation of money. (The reasons, it should be recalled, are four: First, the effect of an expanding quantity of money on the prospect for prices rising and thus being able to gain by buying sooner rather than later. Second, the effect on the prospect for being able to dispose of inventories and other assets easily and profitably. Third, the effect on the prospect for being able to borrow easily and profitably. Finally, the effect of an expanding quantity of money on nominal interest rates, which is to encourage the lending out of shortterm funds that it otherwise would not have been worthwhile to lend out. 23 ) To not only end the rise in velocity, but to bring it crashing down, nothing more is required than to cut back on the rate of increase in the quantity of money on which the rise in velocity rests. To the extent that that is done, all of the factors artificially reducing the demand for money for holding and thereby elevating velocity are removed, with the result that the demand for money for holding is restored and velocity falls correspondingly.
Experience of the last decade provides ready confirmation of this conclusion no less than it does of the ease with which a reduction in the rate of increase in the quantity of money can put an end to “wage push” and all other varieties of “cost push.” Reduction in the rate of increase in the quantity of money both in the early 1980s and then again in 1989 and most of 1990, following years of more rapid rates of increase in the quantity of money, was on the point of so increasing the demand for money for holding and so reducing velocity, that the result both times was a major recession marked by a close approach to the precipice of a major depression. In both cases a plunge in velocity and the onset of a major depression were avoided only by the resumption of a substantially more rapid rate of increase in the quantity of money.
Thus, just as in the case of the wage-push doctrine,
and all the other variants of the cost-push doctrine, the intellectual zone of explanation previously claimed by the velocity doctrine should henceforth be regarded as annexed by the quantity theory of money. For it is the growth in the quantity of money that explains the inflationary rise in the velocity of circulation of money.
It is necessary to anticipate and lay to rest a speculation that could arise concerning the possibility of some form of “cost push” causing an increase in velocity. To understand why cost push cannot have any significant effect on velocity, we need only imagine an arbitrary rise in prices achieved by cost push—say, a 10 percent increase in prices. The reason velocity could not rise is because in order to pay these higher prices, individuals and business firms would need to increase their cash holdings. (For proof, the reader should consider the effect on his need to hold cash if his rent, food bill, and so on were increased by an average of 10 percent. In such a case he would have to hold a correspondingly larger checking balance and carry correspondingly more currency.)
Indeed, the additional need to hold cash may appear to imply that velocity would actually fall as the result of a rise in prices caused by cost push. However, this too would be an error. What would actually happen is that some individuals would end up holding more money to make their purchases and pay their bills at higher prices, while other individuals, who would be unemployed, would end up holding less money, in accordance with their loss of income and ability to purchase. Business firms on the average would also end up not needing to hold any more money than previously; they would need to hold more money per unit of the things they bought, in order to pay the higher prices of those things, but, at the same time, they would, on the average, buy fewer units. Thus their need to hold cash in the aggregate would be unchanged.
8. Critique of the “Inflation-Psychology” Doctrine
A leading variant of the velocity doctrine is the “inflation-psychology” doctrine. As used by its supporters, the term “inflation psychology” is supposed to refer to an uncaused primary. That is, people allegedly have an inflation psychology, and that is supposed to be the ultimate cause of inflation. Why people have an inflation psychology is a question that is not raised, let alone answered. They simply have it, and because they have it, they spend more rapidly.
Of course, there is such a thing as inflation psychology, but it is not a primary. It is based on the fact of inflation. It comes into existence only after many years of inflation. Properly understood, what the term “inflation psychology” really refers to is the various ways in which a rapidly expanding quantity of money reduces the desire of people to hold money. Properly used, the term embraces the four connections we have traced between an expanding quantity of money and a rising velocity of circulation of money.
Inflation psychology actually refers to more than these connections between an expanding quantity of money and a rising velocity of money. It refers to more, because these connections have an effect on prices only by way of raising aggregate demand. Inflation psychology also has an influence on prices from the side of supply, because it influences the expectations of sellers. For example, if businessmen come to anticipate that in the years ahead inflation will raise the replacement costs of their plant and equipment, they may begin to raise prices today, in order to be in a position to accumulate sufficient replacement funds. Similarly, workers may demand wage increases in advance, in order to cover the rise in prices they expect to occur over the life of their employment contracts. Landlords may demand rent increases to cover the rise in prices and costs they expect to occur over the life of their rental contracts. And lenders may demand interest rates high enough to cover the increase in prices they expect to occur over the life of their loan contracts. These forces cause a rise in prices beyond the levels appropriate to the current size of demand—they make the rise in prices outrun the rise in demand by gearing this year’s prices, in effect, to the expected demand of next year and beyond. These price increases operate as a kind of “cost push,” but, of course, one that is entirely induced by the expansion in the quantity of money and rise in aggregate demand; and they have the same limits as any other price increases coming in the form of cost push—namely, the limits imposed by reductions in the quantity of goods that can be sold and by mounting unemployment.
Because of the widespread belief that inflation is a means of preventing and combatting unemployment and achieving full employment, it cannot be stressed too strongly that when it reaches the stage of inducing sellers to raise prices in advance of the current rise in aggregate demand, its effect is actually to cause unemployment. Because insofar as the rise in wages and prices outstrips the rise in demand, the supply of goods that can be sold and the quantity of labor that can be employed must fall.
Now sometimes, when the government makes an effort to cut back on inflation, and really does reduce the rate at which it expands the money supply for a while, some observers, who are familiar with the quantity theory of money, are surprised to see that prices continue to
rise at a substantial rate. And they take this fact as evidence against the quantity theory, claiming that it shows that inflation psychology exists and is leading a life of its own, as it were.
The error in this reasoning is not hard to find. So long as our money is a paper money, that the government can inflate as much as it likes, there is no reason for people to believe that the government will not soon resume a more rapid rate of inflation—especially in view of the fact that the whole philosophy of the mixed economy drives it to do so. In order to convince people that it is serious in its determination to end inflation, the government must restrict its increase in the quantity of money for a protracted period. In the meanwhile, however, because people have had no reason to believe that the government will continue to limit itself, they will probably have placed themselves in even more overextended positions, in which they are operating with even lower money balances, have further increased their borrowings, and are asking still higher wages and prices—all in the expectation that inflation will come to their rescue and provide justification for their action. In this context, stopping the inflation or significantly restricting it must precipitate a crisis. And then the government must either allow the crisis to occur or, to avoid it, give in and fulfill people’s expectation that inflation will resume.
It would be a serious mistake to describe this situation by saying that the government is forced to resume inflating in response to the inflation psychology of the people. It is the government’s ability to inflate, and its repeated use of that ability in the past, that created the inflation psychology and that makes the consequences of finally stopping the inflation so severe.
This type of situation illustrates an inherent flaw of paper money. The fact that paper money can be inflated, and over time is inflated, causes expectations about future inflation. The existence of these expectations then makes it impossible to stop inflating without a crisis, while the threat of the crisis induces the government to resume and accelerate the inflation. Inflation psychology is an inevitable consequence of paper money and is a critical step in its ultimate downfall.
The events of the 1960s and 1970s in the United States provide clear confirmation of this process. Each time the government attempted to slow down the increase in the quantity of money, a crisis began to develop, and it quickly resumed the increase, and at an accelerated rate. The result was a growing expectation of continued and accelerating inflation. The policy adopted by the U.S. government in the early 1980s, which was carried to the point of producing a very major recession—a depression, according to many—represented the first serious interruption in the process of accelerating inflation since
1933. In 1989 and most of 1990, hardly any increase whatever occurred in the quantity of money. The effect of these two sustained reductions in the rate of increase in the quantity of money was a radical reduction in the amount of inflation psychology that existed. Indeed, the reduction in inflation psychology between 1990 and 1992 was so great that it was possible to discern a growing deflationary psychology.
It should be realized that under a gold standard, inflation psychology could not exist to anywhere near the degree to which it exists under a system of fiat money. This is because under a gold standard, it would have little or no factual basis. To the extent such a psychology began to develop, it would quickly run up against the fact that the money supply did not keep up with it, because it simply could not. At that point, the consequence would be that inflation psychology would disappear.
This is true even of a fractional-reserve gold standard. During the phase in which banks are in a position to expand the quantity of money more rapidly than the supply of gold, there is a limited inflation and some degree of inflation psychology develops, at least to the extent of people taking for granted the ability easily and profitably to borrow and to liquidate inventories and other assets in the face of a rising demand. But as soon as it becomes necessary for the banks to limit the rate of increase in the quantity of money to the rate of increase in the supply of gold, or less, in order to rebuild their gold reserves, these aspects of inflation psychology disappear. They are wiped out in the face of a tightening of credit and an unexpectedly low demand for goods and services.
A 100-percent-gold-reserve system would be characterized by the lowest possible degree of inflation psychology, that is, typically, by none whatever. Under such a system, the quantity of money could never increase more rapidly than the supply of gold. Under such a system, the only possible source of something akin to inflation psychology would be unduly rapid increases in the supply of gold itself, which can never occur at anything remotely approaching the rates of increase in the quantity of money achievable under a system of fiat money. 24
9. Critique of the CreditCard Doctrine
A second variant of the velocity doctrine is the creditcard doctrine. The supporters of the creditcard doctrine view credit cards as making possible a rise in spending without any expansion in the quantity of money. They observe, for example, that people who carry credit cards do not need to carry as much currency as previously, and they conclude on this basis that credit cards contribute to
a rise in the velocity of money, by making possible more spending in relation to the same quantity of money.
The first objection to be made to the creditcard doctrine is that much of the reduction it makes possible in the need to hold money is merely apparent, and not real. This is the case insofar as credit cards are actually used in making purchases.
To prove this point, let us consider the case of cards like the American Express card, in which all charges must be paid within a few weeks. The holder of such a card need not carry as much currency in his pocket—that is certainly true. But he must have money to pay his creditcard bill when it comes due. As a result, the money that such an individual is spared from holding in currency, he must hold in his checking account, in order to be able to pay his creditcard bill.
Of course, in some cases, an individual might use his credit card and not immediately set anything aside for the payment of his creditcard bill. For example, he might decide to pay his bill out of his next paycheck, which is not to be received for one or two weeks. Even in these cases, however, it is a mistake to believe that credit cards increase the velocity of circulation. Because while the individual card holder can spend money he does not have, the creditcard company, or the supplier from whom the card holder buys, must be in possession of the necessary funds to pay for his purchases. If the creditcard company must pay the supplier immediately, then what occurs is essentially no different than if the card holder went to the creditcard company, borrowed money and then paid for his purchases with cash. If there is some delay in payment by the creditcard company, then the supplier is placed in the position of having to extend credit. But to be able to do this, he has to obtain additional financing, because while his money revenues temporarily drop, he continues to need just as much money as before to pay his own suppliers and meet his own personal commitments. Thus, he has to borrow correspondingly more; what occurs here is the equivalent of the supplier borrowing money for his customer, which the customer then spends in the supplier’s shop. In either case, it is not that the creditcard holder’s spending takes place without the existence of money, but that, in effect, he borrows and spends the money of a lender. Total spending in relation to the quantity of money is unchanged in these cases.
Indeed, on the basis of this discussion, we must conclude that particularly in the case of credit cards in which all the charges come due within a short period, it is probably true that the overall need to hold money is increased rather than decreased. This is because not only must money still be held to pay for the creditcard holder’s purchases but, in addition, as we have seen, the creditcard holder needs to hold money to pay his creditcard bill when it comes due. Thus, there are now two transactions and a need for two cash holdings, whereas before there was only one transaction and a need for only one cash holding. Before the existence of credit cards, an individual who went to a restaurant, say, had to carry currency to pay his restaurant bill. Now, equivalent money must be held either by the creditcard company or by the restaurant, to finance his purchase. In addition, the creditcard holder must hold money to pay his creditcard bill when it comes due. Thus, two cash holdings are required in place of one, to effect the same purchase of goods and services. The necessary tendency of such a state of affairs is to reduce the aggregate demand for consumers’ goods in relation to the quantity of money. For the situation is one of greater complexity of the productive process, with more stages of buying and selling being present and thus requiring diversion of funds from expenditures for consumers’ goods to expenditures at a different stage of transactions.
Conditions are not significantly different in the case of credit cards that can be paid off gradually over many months, like the Visa card or Mastercard. In practice, of course, many people use these cards in just the same way as the American-Express-type card and pay off their creditcard balances in full each month. But insofar as the balances on these cards are paid off in modest amounts over a period of years, the effect is initially to increase the demand for money for holding by less than in the case of the American-Express-type card and then, in all the succeeding months, to increase it by more. In the first month there is a demand for money to finance the purchase of the merchandise plus a modest demand for money to pay the installment on the credit card, instead of a demand for money to finance the purchase of the merchandise plus an equivalent demand for money to pay off the creditcard balance. But in each succeeding month there is a demand for money to pay an installment on the creditcard debt, plus interest, whereas there is no such demand for money in the case of the American-Express-type card.
The aspect in which credit cards do reduce the demand for money for holding is insofar as they are not actually used but merely provide their holders with the potential for use. To this extent, they represent the possession of guaranteed lines of bank credit. That is, whoever has such a card has the right to borrow up to some agreed-upon sum to be provided by the banks involved, any time he wishes. And to this extent, credit cards can in fact reduce the amount of money that people need to hold to some degree. They do so in cases in which a person was previously holding money on the chance that he might come across something he wanted to buy and was uncer—
tain that he would be able to obtain a loan to buy it. Such a person need not hold that money now. His loan is guaranteed in advance by virtue of his possession of the credit card and the line of credit it conveys.
But now we must ask how it happened that the banks could extend lines of credit to people who previously would have been uncertain of being able to obtain loans for specific purposes. The answer to this question brings us back once again to the quantity theory of money. The banks can extend additional lines of credit because they are in a position to expand the money supply by creating checking deposits that they can lend out. Thus, what we are dealing with in this case is nothing but the influence of an expanding money supply on the availability of credit and the demand for money. We have already seen how the increase in the quantity of money entering the economic system in this way operates to reduce the demand for money. The existence of credit cards based on this foundation means merely that the ability of the banks to expand the money supply enables consumers as well as business enterprises to attempt to reduce their holdings of money, with the same effect on the velocity of money. Thus, to the extent that credit cards do in fact raise velocity, the rise must be considered merely a further symptom of the expanding quantity of money.
The objection might be raised that even without the banks’ ability to create money, credit cards would still have come into existence and might still have reduced the need to hold money on the part of the holders of the cards. That is probably true to some extent. But in the absence of the banks’ ability to inflate, the extension of additional lines of credit would be strictly limited, and the only way that the banks could extend additional lines of credit at all—whether to consumers holding credit cards or to any other type of borrower—would be as a result of the availability of the necessary savings.
These savings could only become available either as the result of the withdrawal of savings from other uses, or as the result of an increase in the overall supply of savings. Either way, if the base of the additional lines of credit is savings, then what is presupposed at the very beginning is a corresponding reduction in spending somewhere else in the economic system. That is, either spending financed by the use of savings will be less somewhere else or, if the overall supply of savings available for use is increased, consumer demand will be less, because the existence of the additional savings is possible only to the degree that people consume less. Lines of credit based on savings, therefore, cannot be presumed to raise the overall volume of spending, because the origin of such lines of credit is a reduction in spending somewhere else in the economic system.
10. Critique of the Consumer-Installment-Credit Doctrine
Still another variant of the velocity doctrine is the doctrine of consumer-installment credit. According to this doctrine, prices rise because the granting of consumer-installment credit enables consumers to make an additional demand for goods.
Here, consistent with the principles presented in the preceding section, it is necessary to realize that the granting of credit out of savings represents merely a transfer of spending power from some parties to others. The savers must first reduce their consumption. Only then can the savings exist that are made available to borrowers. Or if the savings already exist and are being used, they can be made available for a new use only to the extent that a previous use is curtailed. There is no increase in overall spending whatever, but merely offsetting changes in the extent of particular types of spending, as the result of the granting of credit out of savings. To state the matter as succinctly as possible: credit granted out of savings is not inflationary. Only credit based on the ability to expand the money supply is inflationary.
The installment-credit doctrine is true only to the extent that the credit is granted out of newly created money. It is false to the extent that the credit is granted out of saved funds. Because to the extent that consumers obtain credit out of saved funds, the savers have first had to restrict their consumption before the consumer-borrowers can expand theirs, or some other set of users of the savings has had to restrict its spending. There is no increase in overall spending here, but just a transfer of spending power from one set of buyers to another.
Consequently, once again, an opposing doctrine turns out to confirm the quantity theory of money. For the only way the installment-credit doctrine could possess an element of truth is on the basis of an expanding quantity of money.
The same principle applies to every form of credit: credit granted out of savings is not inflationary. Only credit granted out of newly created money is inflationary.
This principle also applies to every form of debt. The incurrence of debt in and of itself is not inflationary. Debts incurred through the borrowing of savings are not inflationary. Only debts incurred through the borrowing of newly created money are inflationary. When applied to government budget deficits, this means that deficits financed by borrowing from the public—i.e., through the sale of securities to individuals and business firms—are not inflationary (which, of course, is not to say that they do not have other highly destructive consequences 25 ). Only deficits financed by the creation of new and additional money are inflationary.
11. Critique of the Consumer-Greed Doctrine
The claim is sometimes made that inflation is the result of the consumers’ “greed.” Occasionally, it is the consumers’ mere desire for a better life that is named as the cause of inflation, and in those very words.
The supporters of the consumer-greed doctrine appear to have in mind a case in which the consumers simply go out and overbid one another in their desire for more goods. It is possible that the supporters of the doctrine have in mind the scene of an auction in which the bidders scramble for a limited number of items and drive prices to high levels in their enthusiasm.
Such action on the part of consumers could explain how the price of a few items might rise. But it cannot explain how the general price level rises. It cannot, because it does not tell us where the consumers obtain the money to start spending more for everything. If the consumers do not have more money available in toto, then they can bid up the prices of some things only by correspondingly reducing their purchases of other things. But that implies that the prices of these other things tend to fall. No problem of inflation would exist, therefore. Nor is it reasonable to assume that “greed” somehow leads the consumers to reduce their demand for money for holding. Indeed, the only thing that could make such behavior the “greedy” thing to do, rather than continuing to maintain the same demand for money as before, would be if the quantity of money is rapidly increasing, which would provide real incentives for a drop in the demand for money. But this, of course, brings us back once again to the quantity theory of money.
Finally, it should be realized that what the consumer-greed doctrine actually cites as the cause of higher prices is people’s desire for a higher standard of living. That is the meaning of their “greed.” Not only is this not a cause of higher prices, but, in reality, it is the cause of lower prices. Because what people must do to raise their standard of living is produce more and save more. This is exactly what everyone tries to do who is seriously interested in improving his standard of living. Thus, his “greed” is the source not of more spending out of nowhere, but of harder work, more forethought and provision for the future, and thus more production and supply and therefore lower, not higher, prices.
12. The Meaning of Inflation
The preceding discussions of explanations of rising prices other than the quantity theory of money, have served further to confirm the quantity theory of money.
It has been shown that insofar as the alternative explanations contain any kernel of validity at all, it is only as an extension of the quantity theory of money. The increase in the quantity of money and the consequent rise in aggregate demand is what underlies any ability of labor unions to engage in “wage push,” of businessmen to engage in “profit push,” of crises to be accompanied by a general and sustained rise in prices, and of the velocity of circulation to rise in circumstances that are accompanied by rising prices. It is what underlies the existence of all socalled wage-price spirals, of “inflation psychology,” and of any inflationary consequences that can be associated with the use of credit cards, installment credit, or any other form of credit, or with consumer “greed.” Thus, the quantity theory of money rightfully annexes, as it were, the explanatory territory previously claimed by all these opposing theories.
The undue increase in the quantity of money that underlies the rise in prices has, moreover, been shown to be the responsibility of the government. The moneys chosen by the market were, and would be again, gold and silver. These moneys do not increase at a rate sufficient to cause a sustained significant rise in prices. Even what was probably the greatest percentage increase in the supply of these metals in recorded history, which took place in consequence of the Spanish conquest of the New World, was not sufficient to raise prices in Europe by much more than an average of 1 percent per year over the course of the next two centuries. Indeed, for long periods of time, gold and silver are capable of increasing at a lesser rate than the increase in the supply of goods and services in general, and thus, when they serve as money, of being accompanied by falling prices—as was the case in the generation prior to the discovery of the California gold fields in 1848 and in the generation from 1873 to 1896.
It was government interference over a period of more than two centuries that brought about the abandonment of the use of gold and silver as money and thus of the powerful restraint on the increase in the quantity of money that a gold or silver money entails. In the last sixty years or more, the government of the United States, like that of virtually every other country, has had unlimited power to expand the quantity of fiat paper money and has made ample use of that power. 26 Thus, the whole problem of an inflationary rise in prices reduces to an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver or, to what is equivalent in view of its role in their abandonment as money, an increase in the quantity of money caused by the government.
All of the knowledge concerning the cause of rising prices presented so far in this chapter and in Chapter 12,
can be summarized in a definition of inflation as, precisely, an increase in the quantity of money more rapid than the increase in the supply of gold and silver, which is to say, an increase in the quantity of money caused by the government. 27
This is a definition in terms of fundamental causation, and one which explains all of the major symptoms of inflation: namely, a sustained significant rise in prices, a rise not only in the general price level but in the whole range of prices, debtors being enriched at the expense of creditors, high nominal profit and interest rates, and a low demand for money for holding, among others.
This definition, moreover, shows how to stop inflation: namely, stop the government from creating or sponsoring the creation of money in excess of gold and silver—viz., force the government to reestablish, and/or allow the market to reestablish, the gold and silver monetary system that the government has destroyed. This will put an end to inflation and all of its symptoms.
In sharpest contrast, the usual definition of inflation that is offered, which is “rising prices,” provides no knowledge of causation. As I have shown, it perpetuates ignorance and confusion by making it possible for a wide variety of things to appear as possible causes of inflation, thereby making it impossible to be confident of the explanation in any given case. Furthermore, the definition of inflation as rising prices implies that businessmen are always the parties directly responsible for inflation, since they are the ones who decide such things as whether or not prices posted on store shelves or listed in catalogues are to be increased. And, of course, the definition of inflation as rising prices supports the corollary belief that inflation can be remedied by price-and-wage controls, since, according to it, the absence of price and wage increases that can result from such controls means the absence of inflation. 28
Ironically, the definition of inflation as rising prices serves actually to promote inflation. It does so in part by implying that price controls are the remedy for inflation. For once price controls are enacted, the government feels free to inflate the money supply all the more rapidly, in the mistaken belief that merely because prices cannot rise, it does not have to worry about inflation—as though because the symptom was gone, the underlying cause of the symptom was also gone. The definition of inflation as rising prices also serves to promote inflation by suggesting government subsidies to keep down prices, which subsidies are likely to be financed by creating still more money. Thus, for example, in believing that it reduces inflation by keeping down the price of bread and milk, say, by means of paying subsidies to cover the losses entailed in their sale at artificially low prices, the government may very well be led to increase the quantity of money more rapidly, in order to obtain the funds with which to pay these subsidies. In this way, the government resorts to more inflation in order to fight a symptom of inflation. 29 Probably the leading instance of this bizarre practice is the pursuit of a socalled easy-money policy for the purpose of holding down interest rates. High interest rates are mistakenly believed to be a cause of rising prices, rather than the effect of the rapid increase in the quantity of money. The result of such ignorance concerning inflation is that the increase in the quantity of money is made still more rapid, for the purpose of keeping down interest rates.
In addition, the definition of inflation as rising prices makes no distinction between higher prices which are the result of more demand or of less supply. And thus it perpetuates the confusion that things which cause less supply are responsible for inflation. Finally, this definition is incapable of contributing anything whatever to the explanation of symptoms of inflation other than the rise in the general consumer price level—for example, such symptoms as a rise in the whole range of prices, debtors being enriched at the expense of creditors, high nominal profit and interest rates, and a low demand for money for holding.
The importance of determining which of these two contending definitions of inflation—rising prices or an increase in the quantity of money more rapid than the increase in precious metals—is the proper one, cannot be overestimated. The difference between them is as important as the difference between holding a right or a wrong understanding of a disease—of knowing what it is that causes all the symptoms of the disease and what needs to be dealt with to eliminate the source of the symptoms, versus attempting to deal directly with an isolated symptom. Thinking of inflation as being nothing more than rising prices is comparable to thinking of a disease as consisting of nothing more than a high temperature reading, say, which would imply that the remedy is as simple and as absurd as packing the thermometer employed to take the temperature in ice—a remedy that would be on the same intellectual level as imposing price controls as the cure for inflation. It is comparable to thinking that a problem of excessive pressure in a boiler is merely one of movement of the pressure gauge and that the pressure can be brought down by forcing the gauge to a lower reading—another solution on the intellectual level of the enactment of price controls.
Correctly understanding the meaning of inflation— that is, in terms of an increase in the quantity of money— makes it possible to realize that inflation can be present without the appearance of any of its obvious symptoms,
just as a disease, such as cancer, can be present prior to the appearance of any of its obvious symptoms, and that inflation continues to be present even though some particular leading symptom, such as rising prices, has been suppressed.
Of no less importance is the fact that a correct understanding of what inflation is, makes it possible to raise questions about the causes and consequences of inflation that would otherwise simply be impossible to raise, because one would still be bogged down in trying to determine the cause and consequences of rising prices in a given case. When one has finally thoroughly investigated the causes of rising prices, as we have done, and arrived at the definitive knowledge that only an increase in the quantity of money, specifically an increase more rapid than the increase in the supply of gold and silver— an increase caused by the government—can qualify as an explanation that is consistent with all of the facts, one is able to raise questions pertaining to whole new vistas of causes and effects.
For example, in the next part of this chapter, in asking the question of what are the causes of inflation, we no longer ask the question of what are the causes of rising prices. We now, once and for all, already know the answer to that question. It is cemented and conveyed in the proper definition of inflation. Thus, in asking what are the causes of inflation, we now go further and ask: What are the causes of the increase in the quantity of money at a rate more rapid than the increase in gold and silver? Namely, what leads the government to bring about such an increase in the quantity of money? When it is understood that inflation is, in fact, fundamentally a government policy, not a phenomenon of prices, the question of causation is pushed back to the plane of the intellectual and ideological influences acting on the government when it pursues that policy, and on the citizenry when it supports or calls for the government’s policy of inflation.
Similarly, in asking about the consequences of inflation, we are no longer limited to asking about the consequences of rising prices. We can raise questions about all the consequences of the undue increase in the quantity of money. These consequences go far beyond rising prices and must be understood if one is to understand the effects of inflation, including the effects of the rising prices inflation causes.
In sum, on the basis of a sound definition of inflation, one is led to ask much more fundamental, wider, and better questions. On the basis of this foundation, it is now possible to turn to a discussion of what I have titled “the deeper roots and further effects of inflation.”
PART B
THE DEEPER ROOTS AND FURTHER
EFFECTS OF INFLATION
1. The Connection Between Inflation and Government Budget Deficits
Inflation as a government policy is intimately connected with deficits in the government’s budget. It is not the case that deficits in and of themselves are inflationary, as is often claimed. If they are financed by selling bonds to the “public”—that is, to private individuals and nonbank corporations—there is no increase in the quantity of money or in aggregate demand. There is merely a diversion of demand: the government spends instead of private borrowers, who are deprived of the funds the government borrows and who must therefore spend correspondingly less. 30
Indeed, under a gold standard, deficits financed by borrowing from the public can actually be deflationary, by virtue of threatening government bankruptcy and accompanying political instability, as was shown in the critique of Keynesian policies in the preceding chapter. 31 These consequences increase the demand for money for holding, cause the export of gold, and threaten the solvency of the banking system insofar as the banks hold government securities as an asset backing fiduciary media. The fact that under a gold standard deficits represent an equivalent drain of savings away from private borrowers, who, for the most part, would have used the savings for the purpose of capital investment, means that they also result in diminished economic progress and, indeed, if practiced on a sufficiently large scale, in the outright economic decline of the country. These destructive tendencies are reinforced by the increase in tax burdens to finance the growing burden of interest and principal payments entailed in a policy of deficits. As a result, the country’s relative position in world commerce is impaired, which, if severe enough, also contributes to a decline in the quantity of money that circulates within its borders. 32
What makes government deficits inflationary is the ability to finance them by the creation of new and additional money. When they are financed in this manner, the government can spend more and the citizens need not spend any less. Indeed, very soon—once the new and additional money begins to reach them—the citizens too begin to increase their spending. The increase in the quantity of money works its way through the economic system, and as it continues, spending increases in more and more areas, until it rises virtually everywhere. It goes
on rising so long as the deficits are financed by means of the creation of new and additional money. 33
The ability to finance peacetime deficits by means of the creation of new and additional money has existed in the United States since the abandonment of the domestically convertible gold standard in 1933. Prior to that time, the U.S. government was obliged to redeem paper dollars on demand at the rate of one ounce of gold for every $20.67 of paper. The dollars could be redeemed by anyone, including American citizens. In addition, gold reserves of at least 25 percent against National Bank notes, Federal Reserve notes, and Federal Reserve deposit liabilities were mandated by law. These requirements sharply limited the government’s ability to expand the supply of currency and bank reserves and correspondingly limited the ability of the commercial banking system to increase the supply of fiduciary media. In such circumstances, it was simply impossible to rely on the creation of money as the means of financing budget deficits. This was because of an impending deficiency of gold reserves. The deficiency of gold reserves would come about by virtue both of an absolute loss of gold reserves in redemptions of paper money for gold and an increase in the amount of money against which reserves were required to be held. 34
Even though from 1933 to 1965 the United States retained substantial gold-reserve requirements against Federal Reserve notes and deposit liabilities, these requirements ceased to be effective once the government increased the official price of gold to $35 per ounce and thereby increased its gold reserve by almost 75 percent overnight. And then, from the late 1930s until 1945, the U.S. government came into possession of a vast portion of the rest of the world’s monetary gold, as many nations used their gold reserves to buy American supplies. As a result, over almost all of this period, the U.S. government was able to create additional paper money as rapidly as it wished, without being limited by a deficiency of gold reserves. When the problem of a deficiency of gold reserves began to develop—as the result of more than a decade of substantial losses of gold reserves in the London gold market and the growing gold-reserve requirements accompanying the increased quantity of Federal Reserve notes and deposit liabilities outstanding—the gold-reserve requirements were simply abolished, and, not long thereafter, the policy of holding the price of gold at $35 per ounce, as well. 35
Prior to 1933, the government did finance wartime deficits by means of creating money. But it had to resort to extraordinary measures in order to do so. To be able to create money for the financing of deficits in the Civil War, it abandoned the requirement of convertibility to gold and issued irredeemable greenbacks. It also established the National Banking System with its National Bank notes, which made possible an increase in the quantity of money in the economic system relative to the amount of gold, as National Bank notes, backed 25 percent by gold, came to be used in place of gold coin. In World War I, the government required the banks to turn over their gold reserves to the Federal Reserve System, and to count as their reserves equivalent checking-deposit balances with the Federal Reserve System. The Federal Reserve System then used this gold to support a multiple expansion in its own notes and deposit liabilities, on the basis of which the banking system was able to expand the supply of fiduciary media correspondingly. 36
The ability to finance deficits by means of inflation exists today at the federal-government level, but not at the state-or local-government level. Hence only federal deficits can be inflationary. And inasmuch as state and local governments lack the ability to inflate the money supply to finance their deficits, they almost always choose to pursue a policy of balanced budgets—with all of their expenditures financed by current tax revenues. They recognize, implicitly at least, that given their inability to create money to pay their creditors, a policy of deficits on their part would result in bankruptcy. To adopt a policy of deficits, a state or local government must be reckless, corrupt, or ignorant to a very high degree. The government of New York City, which came to the edge of bankruptcy in the mid-1970s before being rescued by the state and federal government, provides the only recent significant example of such a local government.
The mechanism of creating money in order to finance deficits has already been explained. It is the purchase of government securities by the Federal Reserve System, which is accompanied by the creation of new and additional checking deposits for the Treasury. When recipients of the new and additional money spent by the Treasury make additional deposits in their checking accounts, the result is additional standard money reserves for the banking system. 37 On the basis of its additional reserves, the banking system in turn can expand the supply of fiduciary media and thereby provide the Treasury with still more new and additional money to spend. (The same state of affairs exists in foreign countries. All one need do is substitute for the Federal Reserve System the name of the appropriate foreign central bank.)
The ability to create money makes it impossible for the federal government to go bankrupt in the technical sense of lacking the dollars required to pay its creditors. So long as what it owes is dollars, and it has the power to create new and additional dollars, it will always have money available to pay its debts. The fact that in the technical sense the government cannot go bankrupt un—
der these conditions, no matter how large its debt becomes, should not be at all surprising. An individual citizen would never go bankrupt either, no matter how much debt he incurred, if he owned a printing press and, whenever the need arose, could just go and run off whatever dollars his creditors required. Precisely this is the position of the federal government under our present fiat-money standard.
Furthermore, an important consequence of the government’s creation of money is an increase in its tax revenues, for the money incomes of the citizens are increased by the inflation, and additional taxes are paid on those incomes and on the additional consumer spending that takes place out of those incomes. Indeed, the increase in taxes is almost certain to be more than proportional to the increase in real incomes. This is both because of the progressive nature of the income tax, and thus of the fact that people are pushed into higher brackets and have to pay higher rates of income tax as inflation raises their incomes, and because of the fact that inflation leads to a systematic overstatement of income subject to taxation. Under current federal tax legislation, the upward drift of taxpayers into higher brackets supposedly no longer takes place, since the upper borders of the brackets are supposed to be increased corresponding to the rise in prices each year. After decades, it is welcome to observe some remedy enacted for an obvious abuse. As we will see, however, the more serious problem of the systematic overstatement of income subject to taxation has yet to be addressed. 38
Although, given its ability to inflate the money supply, the government can no longer go bankrupt in the technical sense of lacking the money necessary to pay its bills, it has probably long since been bankrupt in the sense of being unable to repay its debt in the same purchasing power in which the debt was contracted. The present national debt is the sum of the deficits contracted over all of the years since the administration of President Andrew Jackson, when, briefly, there was no national debt. Repayment of the debt in the same purchasing power in which it was contracted would require restating the debt as the sum of the deficits of all the intervening years, with each year’s deficit adjusted for the rise in prices between its incurrence and the present. Thus, the portions of the debt which date from the First and Second World Wars would have to be adjusted upwards by a percentage that was equal to the rise in prices since those times, and similarly with the portions of the debt contracted in the 1950s, 1960s, and 1970s. Such an adjustment, of course, would result in a restatement of the debt at a substantially higher level than its already very high level.
It is extremely unlikely that such a restated debt could ever be repaid. The government would not be able to repay it through inflation, because the more it inflated, the higher would prices rise and the higher therefore would be the restatement of the debt. It is extremely unlikely that even the present national debt, let alone one restated at the substantially higher level necessary to compensate for the loss in the purchasing power of money, can ever be repaid out of taxation. Thus, in real terms—in terms of the ability to repay creditors in the same purchasing power in which they lent—the government is probably bankrupt, and probably has been for many years. For decades, the government has been paying principal and interest in money of substantially lower purchasing power than existed at the time it borrowed the money in question.
The fact that the present national debt is probably beyond the point of any possible repayment in terms of the buying power of the money lent to the government, or even in terms of the present, already sharply reduced buying power of money, may very well help to explain the prevailing high interest rates on longterm government securities—interest rates which for some years have substantially exceeded the rate at which prices have been rising. The height of these interest rates does not have to be explained merely by reference to the likelihood of a reacceleration of inflation and rising prices. Even without such reacceleration, high interest rates on government securities would have to exist to reflect the likelihood that the government is simply unable to repay its current level of debt in real terms, with or without inflation. Interest rates may be high in order to provide a risk premium as well as an inflation premium. 39
If this description of matters is correct, then it may be only a relatively short step from the present situation to one in which it is impossible to sell longterm government securities to any buyer but the government itself— viz., the Federal Reserve System and the Social Security Trust Funds. For private individuals and businesses will simply stop buying such securities when they conclude that, no matter what happens, they must lose by doing so. Such a result would imply a quantum jump in inflation, because then both the entire annual deficit and the redemptions of government securities coming due would have to be financed almost entirely by inflation.
Budget Deficits and the Monetary Unit
The fact that the government has the power to inflate the money supply means, of course, that government spending is not constrained by tax revenues. In the absence of this power, it would be constrained by tax revenues, precisely because a policy of deficits would drive the government into visible bankruptcy. To avoid this specter, any semiresponsible, representative govern—
ment would make a balanced budget a fundamental principle of its operation, just as almost all state and local governments in the United States do. Any federal administration that failed to do so, would soon be turned out of office.
The implication of these facts is that what is required to put an end to the present policy of deficits is to deprive the government of the power to inflate the money supply. Until that is done, all talk about balancing the federal budget is just so many empty words. The talk that comes from the government itself is comparable to a New Year’s resolution to reduce his use of credit cards in the year ahead that is made by someone who has a license to counterfeit and thus can have no problem obtaining the money necessary to pay whatever credit card charges he runs up. When all the government has to do to pay its bills is to go and print more money, even proposals for constitutionally balanced budgets cannot be taken seriously. They have no more binding quality than written New Year’s resolutions. 40
The only thing that will ever force the federal government to balance its budget is if it loses the power to create money, and thus is put in a position in which the money it spends must be obtained from the citizens. That will happen only when the monetary unit of the country becomes something that is physically incapable of being produced at a profit except in very limited quantity, and even then probably not by the government, with all of its bureaucratic inefficiencies. That is to say, the monetary unit must be something whose cost of production is usually almost as great as its own value and, in the face of efforts to increase its production, soon rises as high and even higher than its own value. Gold and silver are monetary units of precisely this description.
When they are the monetary units, the government is physically deprived of the ability to enlarge the money supply beyond the rate at which a free market would enlarge it, unless it wishes to incur a financial loss and thus defeat all purpose it might have in seeking the enlargement of the money supply. 41 Thus, with gold and silver as the monetary units, the government is made dependent on the taxpayers for every dollar it spends, and is faced with the fact that every additional dollar it wishes to spend must be obtained from the taxpayers. As a result, the government simply does not have the money for spending proposals it would like to implement. It is compelled to reject proposals for a sheer lack of funds, or because their implementation would compel it to abandon other activities it considers more important. No longer is the mere “desirability” of a program a sufficient basis for its adoption. No longer can the government proceed under the delusion that its spending enriches the citizenry.
2. The Motives and Rationale for Deficits and
Inflation
The Welfare State
The roots of inflation begin to become clear when it is realized that inflation is desired in large part precisely in order to make possible a policy of continuous budget deficits. Deficits, and the inflation to finance them, are the cornerstone of the welfare state. They are indispensable in order to lend the appearance of reality to the belief that the government is the source of free benefits, which belief is the fundamental delusion underlying the welfare state.
Because the government has the ability to inflate, it can pay for welfare-state programs without having to collect corresponding taxes, and without having to fear driving itself into bankruptcy. On this basis, demagogic politicians have been able to lead people to think of government programs almost exclusively in terms of their alleged benefits, with virtually no regard for their cost. They have been able to depict the alleged benefits of one government program after another—social security, public housing, farm subsidies, rent subsidies, food stamps, foreign aid, aid to education, support of the arts, support of scientific research, medicare, medicaid, child care, and on and on—as though no cost were involved. At each step, the demagogues have been able to depict the opponents of such measures as mere curmudgeons, motivated by sheer ill will toward the mass of mankind. For if the programs really were free, there could be no other motive for opposing them.
Thus, the ability to inflate is highly valued—in effect, to enable adults to believe that the government is Santa Claus.
The effect of this delusion, of course, as we have already seen, is a radical expansion in the size of the government. 42 The popularity and implementation of additional government programs would be far less if it were necessary to finance every additional dollar of government spending with an additional dollar of taxes, as would be the case if the government lacked the power to inflate and thus had to expect bankruptcy as the price of deficits. Then, every time a new measure was proposed, its supporters would be obliged at the same time to explain how its cost was to be paid. Welfare-state programs would cease to appear as free. Rather, they would be perceived as the direct, immediate cause of higher taxes. In such circumstances, the welfare state could not exist.
As matters stand, the supporters of the welfare state are actually able to use the cost of welfare-state projects as the basis for still more government intervention. The
rise in prices that results from the increase in the quantity of money to finance the welfare state, is not perceived as emanating from this cause, but from the greed of businessmen. The welfare state continues to be perceived as the source of free benefits and, alongside of it, businessmen are perceived as the cause of gratuitous evil, with their quest for profits causing the impoverishment of the poor, who must pay ever higher prices. The solutions advanced are that the government must provide still more free benefits, in the form of more and larger welfare-state programs, and—sooner or later—that it must control the prices charged by the evil businessmen, so that the free benefits provided by the wonderful welfare state are not offset by the gratuitous harm the evil businessmen inflict.
Inflation and War Finance
The ability to inflate is also valued because it makes it possible for the government to finance wars which it would not be politically possible to finance through taxation. In effect, it fosters the delusion that, like the welfare state, wars can be carried on without cost. Indeed, because of their being financed by means of inflation, people are actually led to believe that wars are a source of prosperity—because everyone earns more money during a war.
Needless to say, in lending the appearance of reality to these beliefs, the ability to inflate contributes to a greater frequency and duration of wars. In the absence of the ability to finance wars by means of inflation, the prospect of war would be regarded with a dread of its financial and economic consequences no less than of its consequences for human life—because war would then be a time of sharply higher taxes and no increase in money incomes.
Inflation and the “Easy Money” Doctrine
A further root of inflation is the belief that inflation in the form of credit expansion is a means of creating capital and lowering interest rates. If new money is created by the banking system and made available as new and additional loans, then, many businessmen believe, the supply of loanable capital is enlarged and interest rates will fall.
Although held by many of the most eminent and productive members of the economic system, past as well as present, this belief is no less naïve than those of the typical supporters of the welfare state. In fact, it can be described as the businessman’s version of the welfare state, in that it too implies the existence of something for nothing.
As will be shown later in the present chapter, the actual consequence of inflation and credit expansion is not more capital but less, and, along with the undermining of capital formation, the scourge of depressions. 43
Inflation as the Alleged Cure for Unemployment
Probably the most important single root of the policy of inflation in the present day is the belief that inflation is necessary in order to prevent or combat mass unemployment. This notion is implicit in the fallacy that falling prices caused by increased production constitute deflation and thus cause depression and unemployment. 44 On this basis, one is easily led to conclude that steps must be taken to be sure that the quantity of money increases more rapidly—at least to the point of achieving a stable level of prices.
The present-day popularity of the belief that inflation is necessary to deal with unemployment stems, of course, from Keynes, and in the form given it by Keynes this belief powerfully reinforces the other motivations for inflation. The Keynesian doctrine, of course, claims that government budget deficits reduce unemployment and increase output in the economic system by a multiple of the deficits. The additional output of the reemployed workers, which allegedly could not be obtained by any other means, provides not only for the government programs but for much more besides. On this basis, additional government spending supposedly not only costs people nothing, but actually enriches them. In effect, the Keynesian doctrine claims not only that there really is such a thing as a free lunch—paid for by reemployment—but that in people’s efforts to obtain it, they obtain a free breakfast and free dinner as well—namely, the benefit of the additional employment and output that is supposedly “multiplied into being” by virtue of the additional government spending. 45
The errors of the Keynesian system have already been demonstrated, and it should already be clear why inflation is not required to prevent or combat unemployment—indeed, is incapable of doing so—and why, in fact, what is required is a free market in labor and a monetary system based on the principle of 100-percent-gold-and-silver reserves. 46 Previous discussion has also indicated how in setting the stage for financial contractions and depressions, inflation is actually the leading underlying cause of mass unemployment. 47 Subsequent discussion in the present chapter will confirm this fact and show how inflation is a preventive or remedy for unemployment only in the peculiar sense that more drugs are a preventive or remedy for withdrawal symptoms. 48
The Underlying Influence of the Socialist Ideology
If matters are explored at a still deeper level, the pervasive influence of the socialist ideology becomes apparent in the support for inflation.
The expansion in government functions and powers entailed in the growth of the welfare state is a major step toward the establishment of socialism. Both the welfare
state and socialism itself are advocated in the name of the alleged helplessness of the average individual and the alleged omniscience and omnipotence of the State. Inflation creates the appearance of just such a relationship between the individual and the State: on the one side stands the individual with his unmet needs, and on the other side, the State, with funds not derived from individuals, but miraculously created outside the economic system, out of thin air. Thus, it becomes possible through inflation to perceive the State in actual practice in accordance with the socialists’ fundamental view of it as an all-powerful, merciful, and redeeming Father. Moreover, the advocates of socialism are none too scrupulous in their respect for individual rights (most obviously, but not limited to, property rights) nor, therefore, in the means they are willing to employ to achieve their ends. The Communists, of course, are openly willing to employ force and violence. Less extreme advocates of socialism, it seems, do not scruple to employ the deceptions of inflation to achieve their goals. Perhaps they deceive themselves as much as the voters, for inflation enables them no less than the public to perceive the State as a kindly Father who provides free benefits.
And, of course, in judging the relationship between inflation and the influence of socialism, one should not forget the famous statement attributed to Lenin, that inflation is the surest method of destroying capitalism. Its possible advocacy on this basis too should not be overlooked.
Although it predates the socialist ideology, the “easy money” doctrine is also promoted by its influence. It shares with the socialist ideology the essential conviction that free benefits can be obtained—this time, not in the form of ordinary benefits from the welfare state for ordinary helpless individuals, but in the form of the allegedly costless creation of additional capital and a lower rate of interest for helpless, needy businessmen, who otherwise could not obtain capital. Furthermore, in the hands of Keynes, the logic of the easy money doctrine was pushed to its limits and was thereby transformed into a vehicle for the virtual abolition of profit and interest income. This was Keynes’s doctrine of the “euthanasia of the rentier,” which was designed to achieve the goals of Marxism without the necessity of a revolution. 49
Finally, the belief that inflation is necessary to prevent or combat unemployment is largely an indirect result of the influence of the socialist ideology. This is because the labor legislation and other government interference that creates the problem of mass unemployment in the first place is the result of the influence of the Marxian exploitation theory. In addition, the influence of the exploitation theory prevents any consideration from being given to the possibility that unemployment could be eliminated by means of establishing the freedom of competition in the labor market, so that wage rates would be free to fall. According to the exploitation theory, freedom of competition in the labor market makes possible the exploitation of labor. With the possibility of free competition in the labor market apparently ruled out, inflation and government spending are made to appear as the only means available for solving the problem.
3. Inflation and Deficits Versus Representative Government and Economic Freedom
Since the time of Adam Smith, a fundamental conflict has been perceived between government budget deficits and the consequent accumulation of a national debt, on the one side, and the institution of representative government, on the other. Deficits oblige future generations to pay taxes for the payment of principal and interest on a debt neither they nor their representatives have any role in incurring and which their representatives cannot be present to oppose. Deficits deprive them of all choice and even voice in a matter for which they will later be held responsible. At the same time, deficits and the accumulation of a national debt are accompanied by the rise of a class of public annuitants—the purchasers of the government’s securities—whose investments are guaranteed by the government and who are supported out of tax revenues, irrespective of the fact that those whose taxes must pay their incomes may well not derive even the slightest benefit from the support they must pay.
Even wars should not be financed in this manner, Adam Smith argued, because while the effect may be to make wartime taxes less than they would otherwise have been, the further effect is to encourage and prolong wars and to shorten the periods of peace and capital accumulation. The ultimate effect, Smith pointed out, is that peacetime taxes become as high as wartime taxes would have been without resort to deficits. 50
Everywhere, the effect of deficits and the accumulation of a national debt, Smith held, is to enfeeble countries, by diverting savings from capital accumulation to consumption and by creating a need for higher and more onerous taxes later on to pay principal and interest— taxes that destroy the incentives to produce and the ability to save, and lay the citizens under a yoke of oppression, in the manner of the Spain of his day. 51 (If one thinks of the nooks and crannies into which the eager hands of the Internal Revenue Service now extend, under the pressure of our own deficits, it is easy to think that Smith was writing of our time.) And ultimately, once national debts reach a certain size, Smith pointed out, they are never fairly and fully repaid. The only release from their burden, he showed, is a government bank—
ruptcy, either open and avowed or in the form of a pretended payment in depreciated currency. 52
When the government has the power to inflate and deficits can be financed by the use of that power, the effect is to make government spending free of the will of the citizens and their representatives. For the government is now in a position to finance its expenditures with funds it does not obtain from the people. Even to the extent the government’s expenditures have the approval of the citizens and their representatives, the approval is gained fraudulently—it is gained under the delusion that because the expenditures can be financed by inflation they are not at the expense of the citizens.
Thus, von Mises was absolutely right to describe sound money as belonging in the same category as constitutions and bills of rights, as a safeguard against despotic governmental power, and to describe the gold standard as indispensable to the system of representative government. 53 When the gold standard is overthrown and the government gains the power to spend funds it does not have to obtain from the people, a veritable revolution occurs in the relationship between the government and the people.
When the government need not obtain its funds from the people, but can instead supply the people with funds, it can no longer easily be viewed as deriving its powers and rights from the people. The ability to inflate enables the government to throw off its status as the servant of the people, deriving its just powers from the consent of the governed, and to appear instead in the guise of the Provider and Father of the people, with the people deriving their existence, powers, and rights from the government. A greater revolution in the relationship between the people and the government cannot be imagined. Yet that is the revolution that the power to inflate has operated to effect in the circumstances and in the psychology of the American people of today. Hardly a year passes but they do not willingly sacrifice some further portion of their inheritance of freedom for some imagined largesse from the government.
In such a state of affairs not only does the government go on growing in size from year to year, both absolutely and relative to the rest of the economic system, but the only ultimate stopping point becomes a totalitarian socialist dictatorship, comparable to the dictatorships of Hitler and Stalin. The stage for such a dictatorship is set when the rising prices caused by inflation are suppressed by means of price and wage controls.
As demonstrated earlier in this book, the enactment of price and wage controls causes shortages and economic chaos, because it destroys the price system. This results in demands that the government seize control over the economic system by means of imposing a system of rationing and the allocation of the factors of production. In this way, the government comes to decide what and how much of each item is to be produced, and by what methods, and who is to receive the product. 54 Finally, as we have seen, the effect of this de facto socialization is to add tyranny to the chaos. The government is not able to solve the problems created by the destruction of the price system, but acquires full power over the newspapers and publishing houses, and over everyone’s employment and standard of living. Caught between the chaos it has created and the responsibility for everyone’s material wellbeing that it has assumed, its continuance in power becomes possible only by ruthless suppression of critics and the creation of an environment of fear and hysteria. Thus, life comes to be characterized by all the hallmarks of a totalitarian state. 55
Between inflation and the enactment of price and wage controls usually lies a period of growing hostility to profit and interest incomes, which incomes inflation sharply increases in nominal terms and reduces or altogether eliminates in real terms. At the same time, inflation brings about a vast redistribution of wealth and income, in the process causing far greater impoverishment than enrichment. The victims, who are unaware of the facts, are led to believe that their suffering is the result of others’ high profit and interest incomes and thus to demand price and wage controls both as a source of relief and as an act of justice.
The next two sections of this chapter will explain these consequences of inflation in close conjunction with its destruction of capital formation. Later sections will elaborate on the propositions that inflation sets the stage for traditional, deflationary depressions and that it causes rather than cures mass unemployment. They will also show why inflation possesses inherent tendencies toward acceleration, culminating in the destruction of the currency and, where the government blocks the development of an alternative currency, of money itself. The chapter will conclude with proposals for the reestablishment of a gold and silver monetary system, in the form of a 100-percent-gold-or-silver reserve against checking deposits and paper currency. It will show why such a system would be both inflation proof and deflation/depression proof, and would possess every other virtue that it is possible for a monetary system to possess.
4. Inflation as the Cause of a Redistribution of Wealth and Income
Inflation destroys the buying power of all assets and incomes which are contractually fixed in terms of a given number of dollars. In this category are savings deposits,
bonds, preferred stock, life insurance policies, and annuities and pensions, as well as employment contracts, sales and rental agreements, and even fire and theft insurance. In raising prices, inflation progressively diminishes the buying power that all these contracts represent.
At the same time, inflation operates to benefit those who are obligated to pay according to the terms of such contracts. It does so by sharply increasing the sums of money they can earn with the same effort and correspondingly reducing the difficulty they experience in obtaining the sums of money necessary to meet their obligations. Thus, businessmen and corporations with debts to pay, the common stockholders of such corporations, homeowners with mortgages, the owners of inventories of commodities of all kinds that are financed with borrowed money, wage earners with personal debts, and the businessmen and wage earners who hold contracts entitling them to buy or rent on fixed terms—all of these groups of people find that the sums of money they are able to obtain from their activities tend greatly to increase and thus to make it very much easier for them to pay the interest and principal on their debts.
Inflation is capable of utterly destroying the buying power of contractually fixed assets and incomes and correspondingly impoverishing those who depend on them, and equivalently relieving from all real obligation those who are obliged to pay according to the relevant contracts. It arbitrarily changes all contractual relations at least to some substantial extent and is capable of destroying them totally. Its potential for achieving a redistribution of real wealth and income is fully comparable to that of a political revolution on the scale of the French or Russian revolutions. It is significant that in both of these revolutions, a major inflation occurred, alongside of the open confiscations and redistributions.
The destruction of the buying power of assets and incomes that are contractually fixed, and the corresponding release from real obligation of those who are obliged to pay according to such contracts, is not the only means by which inflation redistributes wealth and income. As von Mises has shown, inflation never raises all prices and wage rates at the same time and to the same extent. It raises some prices and wage rates ahead of others, or more rapidly than others. Those whose selling prices rise relatively early or more rapidly, gain at the expense of those whose selling prices rise only later on or less rapidly. Inflation shifts the terms of trade in their favor. It makes their goods and services worth relatively more of other people’s goods and services and other people’s goods and services worth relatively less of their goods and services. The relatively higher selling prices of their goods and services means that their revenues and incomes have risen relative to the prices they must pay. At the same time, those whose selling prices have not risen or which lag behind, find their revenues and incomes do not keep pace with the rise in prices, and they correspondingly lose. 56
In addition to the gains inflation provides to various private individuals and groups at the expense of other private individuals and groups, it should never be forgotten that inflation always represents an unearned gain to whoever is in a position to introduce the newly created money into the economic system through his spending— and a corresponding loss to the individuals who make up the rest of the economic system. This party—most often the government or those to whom the government gives the money, but frequently also businessmen with fiduciary media to spend—is able to obtain the goods and services of others merely by virtue of the manufacture of little pieces of paper, or, indeed, merely by virtue of bookkeeping entries. Such a situation represents the receipt of something for nothing, and must be accompanied by an equivalent receipt, somewhere else in the economic system, of nothing for something. Somewhere else in the economic system, others must to the same extent consume less, produce more without consuming more, or suffer a loss in their accumulated capitals (or undergo some combination of these three), in order to compensate for the unearned gains of the spenders of the new money. 57
Ironically, the groups which tend to lose the most as the result of inflation are the relatively poor and helpless—i.e., the very people that the welfare state claims it wishes to help. It is widows and orphans and the elderly, who depend most on the buying power of savings deposits, life insurance policies, pensions, and annuities. Similarly, institutions such as nonprofit hospitals and nonprofit colleges and universities, are also among those most dependent on the buying power of bonds and other contractually fixed assets, which, for the sake of safety of principal, must form a substantial portion of their endowments. It follows that it is inherently dishonest for the welfare state to claim that it seeks to aid these groups and institutions when its inescapable dependence on inflation makes precisely them its worst victims. The welfare state is both an exercise in futility and a fraud. By its nature, it harms those it claims to help. Its advocates have no legitimate reason not to know this.
Eventually, people come to recognize the destructive effects of inflation in redistributing wealth and income, and take steps to protect themselves from them. Thus, interest rates rise in anticipation of the rise in prices to come. The terms of employment, sales, and rental contracts are increased. Price indexing is introduced into various contracts. But these remedies are at best only
partially effective, and create additional problems, namely, unemployment and/or the acceleration of inflation, as will be shown. 58
5. Inflation and the Destruction of Capital
Inflation undermines capital formation in five major ways, which can be described under the following heads: reversal of safety, tax effects, prosperity delusion and overconsumption, malinvestment, and the withdrawal-of-wealth effect. Each of these ways will be considered in turn.
Reversal of Safety
The traditionally safest investments are high-grade corporate bonds, savings deposits, life insurance policies, and government securities. Inflation turns the safety of these investments upside down. It is capable of rendering them the least safe forms of investment. It introduces the risk that the buying power of the proceeds of these investments will be little or nothing. It makes all longterm contracts denominated in a fixed sum of money utterly meaningless, because it places the value of money totally at the mercy of government officials and pressure groups. It is as though one contracted for the delivery of so many tons of coal or board feet of lumber, without the words “ton” or “feet” having any objective meaning and thus subject to the whims of whoever might later care to assert an interest. This is the position of everyone who is contractually entitled to receive fiat money. The only thing he can be certain of is that when he receives the money due him, it will be worth substantially less than it is presently worth.
Yet contractually fixed investments are economically necessary. They are the appropriate investment vehicle for individuals not able or willing to bear substantial risk or to search out and follow more complicated types of investments, such as common stocks. As a result, the destruction of this type of investment deprives a large group of people of the possibility of benefitting from investment. To the extent that the prospect of earning a rate of return on investment constitutes a motive to save, such individuals are deprived of the motive to save. At the same time, they are largely deprived of the means of saving. They are deprived of the means of saving insofar as they are deprived of income on their investments, which income is normally a major source of further saving.
And to the extent they do continue to save, their saving increasingly tends to take an unproductive form. A leading example of the unproductive use of savings that results from inflation is the hoarding of precious metals, whose prospective rise in price in the course of inflation offers people the ability to preserve the purchasing power of their savings. Unfortunately, such hoarding does not contribute to investment.
This is certainly not to criticize the hoarding of precious metals. If the government destroys the traditionally safe investments, such hoarding is the best substitute most individuals have. And it is to everyone’s interest that individuals continue to have the motivation to save, even though their saving takes the form of such hoarding. This is because if the government prevented them from doing even this, and thus totally destroyed the benefit they could derive from saving, it would deprive people of much of their motivation to work. In the absence of being able to save, people would lose the motivation to perform present labor for the sake of providing for their future wants; their only motivation to work would be to satisfy their present wants, which often would not be important enough to justify their labor. Furthermore, it should be realized that the desire to own precious metals need not take the form of hoarding. If the government permitted and enforced contracts calling for payment in precious metals, and if the tax authorities did not tax the rise in their price expressed in terms of paper money, then the precious metals could themselves be lent and so contribute to investment. But this would be tantamount to their remonetization and would mean the transformation of the whole monetary system.
In any case, it is clear that the effect of inflation is to reduce both the motivation to save and the motivation to invest productively such savings as do continue to be made. This obviously impairs the formation of capital, and not only of new capital but also the replacement of existing capital, since people are motivated to consume what they have saved in the past, or to convert it into unproductive hoards. In both ways, the effect is to raise the rate of net consumption. 59
The prospective purchasing power of fiat money rests on a foundation that is far more precarious than the general public realizes. In the first instance, it depends on the rate of increase in the quantity of the money over the period of time that the fixed-sum-ofmoney investments in question are outstanding. Since the rate of increase in the quantity of fiat money is totally at the discretion of government officials, the more fundamental determinants of the rate at which its purchasing power declines are such factors as the government officials’ knowledge of economics, their sense of moral responsibility, and even their method of thinking. This constitutes a truly alarming situation.
The majority of government officials today, and the majority of academic economists, whose ranks supply the advisers of the government officials, do not even firmly acknowledge the truth of the quantity theory of
money. These officials and alleged economists continue to attempt to blame rising prices on almost everything but the increase in the quantity of money. They talk of the greed of businessmen and labor unions, of the price of imported oil, of inflation psychology, of credit cards, and the greed of consumers. In a word, they are wedded to all the fallacies I refuted in the first part of this chapter.
Thus, those who have charge of the increase in the quantity of money, who have the power to increase it as much as they wish, either do not know or will not admit the consequences of increasing it. This is a state of affairs comparable to being in the power of someone who holds a gun but does not know or will not admit the lethal power of his weapon.
Among the government officials and their advisers who do admit the truth of the quantity theory of money, there are many—perhaps a further majority—who believe that what is true in theory is not necessarily true in practice or who, for other reasons, are prepared to act without integrity. In such cases, even a knowledge of the quantity theory of money does not serve as a reliable restraint on the increase in the quantity of money. Closely related to this is the fact that government officials labor under a variety of extremely powerful temptations to use their power to expand the quantity of money. The use of this power is the supreme vote-buying technique: it caters to all the fallacies held by the public about “free” benefits, from free education and medical care to “easy money,” and about what must be done to prevent or combat unemployment. 60
In view of the enormous ignorance concerning the nature of inflation and its effects, the widespread lack of integrity on the part of today’s public officials (and professional intellectuals), and the extremely powerful political motives in support of inflation, there is little hope that, given the power to create money, the government will not use it far beyond the point of prudence. Moreover, because of the inherent accelerative tendencies of inflation, yet to be explained, the rate at which the government is motivated to increase the quantity of money is steadily increased as inflation becomes more rapid. 61
Thus, investments denominated in fixed sums of money are in fact transformed from the safest into the most speculative and risky from the perspective of the purchasing power they will provide. This is a situation which must increasingly undermine saving and investment by the broad classes of the public that depend on such investments.
Tax Effects
As was shown earlier, inflation simultaneously increases nominal profit incomes, which are subject to tax, and the replacement prices of capital assets. It creates profit incomes most or all of which are required merely for the replacement of assets at the higher prices it causes, but which cannot be applied to replacement because they are taxed away as though they were genuine income.
Previous discussion of this fact used an example in terms of inventories. The example showed that despite earning a sharply higher nominal rate of profit as the result of inflation, the typical merchant is placed in a position in which, after making the necessary replacement allowance for the assets needed to continue his existing operations, his ability either personally to consume or to save and expand his business, is actually radically reduced. 62 The following example illustrates the same principle in application to fixed assets, such as plant and equipment and buildings.
As can be seen in Table 19–1, I assume that a machine (or any other form of fixed capital) initially costs $1 million and lasts 10 years. The annual depreciation on this machine, using the common, straight-line method, is thus $100,000. I assume that initially, without inflation, the machine is used to produce a quantity of goods each year that sells for $1 million. I further assume that operating costs—the cost of the labor, fuel, and materials required to produce these goods—are $850,000 per year. Thus, the firm’s annual gross profit (its profit before deduction of depreciation cost) is $150,000 per year.
After deducting depreciation, the firm’s net profit is $50,000 per year. If the firm must pay a 50 percent income tax on its profit, its aftertax profit is $25,000 per year. If, out of that sum, it pays a dividend of $10,000, then it has $15,000 left with which to expand its operations. This is the situation shown in the column labeled “Without Inflation.”
Now let us imagine that between the time the firm buys its machine and the time at which it will have to replace it, an increase in the quantity of money and volume of spending occurs which doubles the firm’s sales revenues and operating costs, and, of course, the replacement price of a new machine. Under these conditions, the firm will have an annual gross profit of $300,000 ($2 million in sales revenues minus $1.7 million in operating costs). However, because the purchase price of its machine is not affected retroactively, its deduction for depreciation on its existing machine remains at only $100,000. Its net profit before taxes is therefore raised to $200,000 per year—quadruple its previous net profit of $50,000 per year before taxes. If the firm still pays the same, 50 percent tax rate, its net profit after taxes is $100,000 per year, which is also quadruple what it was initially.
The apparent quadrupling of profits seems wonderful indeed, until we consider the need to replace the machine
Table 19–1
Effect of Inflation on the Nominal Rate of Profit and the Taxation of Profits
A machine (or any other form of fixed capital) costs $1,000,000 and lasts 10 years.
Without Inflation With Inflation
Sales Revenues $1,000,000 $2,000,000
Operating Costs 850,000 1,700,000
Gross Profit 150,000 300,000
Depreciation 100,000 100,000
Net Profit Before Tax 50,000 200,000
Tax (50%) 25,000 100,000
Net Profit After Tax 25,000 100,000
Necessary Reserve for
NONE 100,000
Replacement at Higher Prices
Available for Consumption or
25,000 NONE
Expansion
Dividend 10,000 10,000
Reinvested Earnings 15,000 (10,000)
at a price of $2 million instead of only $1 million. When nominal profit of $25,000 earned without inflation is we do this, the seemingly rosy picture of enormous sufficient to make possible consumption or expansion to profits turns into something very different. For then it its full extent. Thus, under inflation, if the firm pays even becomes clear that if our firm gives to its stockholders the same dividend it previously paid—$10,000 per year— any dividend at all, it must impair its ability to continue let alone the substantially larger dividend its stockhold-doing business on the same scale, because the whole of ers are almost certain to clamor for in view of its sharply the firm’s seemingly larger profit each year is required increased “profits,” it cannot generate the funds it re-merely to enable it to replace its machine at the now quires for replacement. As is shown in the table, its higher replacement cost. That is, in order to accumulate reinvested earnings must fall by an amount equivalent to the replacement sum of $2 million, our firm needs to set that $10,000. (The reduction of $10,000 in reinvested aside $200,000 for each of 10 years. This sum, however, earnings should be understood as being in real terms, not is equal to its annual depreciation of $100,000 plus the nominal terms. In nominal terms, if the firm pays a whole of its aftertax “profit” of $100,000. In the table, $10,000 dividend, its nominal capital will rise by $90,000. this is shown by means of the row labeled “Necessary Its problem is that to maintain its physical capital intact, Reserve for Replacement at Higher Prices,” the amount it needs to increase its nominal capital by $100,000, not of which is “NONE” in the column labeled “Without just $90,000.)
Inflation,” and $100,000 in the column labeled “With Once again, therefore, we see that to the same extent Inflation.” The table shows that as a result of the need to that inflation provides additional profits, it also requires deduct this reserve under inflation, the funds available that those profits be devoted to the replacement of assets for consumption or expansion from the nominal profit of at higher prices. Yet this fact is largely ignored in the $100,000 turn out to be “NONE,” while the much smaller collection of taxes. What is involved in this case, as well
GOLD VERSUS INFLATION 933 as in the earlier, inventory case, is that as a result of inflation, the firm is taxed not merely on its income, but on funds required for the replacement of its capital as well. If its income properly begins only after full and complete allowance for replacement has been made, then its taxable income should not be viewed as $200,000, but only $100,000, since $100,000 of its apparent profit of $200,000 is actually required to be set aside for replacement. In taxing the firm on $200,000 rather than just $100,000, therefore, the government taxes the firm on the replacement of its capital as well as on its income. To say the same thing in somewhat different words, the firm should be able to deduct the item “Necessary Reserve for Replacement of Assets at Higher Prices” from its pretax income, and thus pay taxes only on the amount remaining thereafter. Instead, of course, the firm is taxed as though the funds required for the replacement of assets at higher prices were income.
In creating profits which are required for the replacement of assets at higher prices and which nevertheless are subject to taxation, inflation operates as the equivalent of a rise in income tax rates on real profits. In the above illustration, its operation is equivalent to raising the rate of income tax on real profits from 50 percent to 100 percent, because it doubles the nominal profit subject to tax, while the real profit earned remains unchanged.
The result of such increases in effective tax rates is that business finds itself with less and less ability to expand or even maintain its operations intact as inflation grows worse. Vast stretches of the Northeast and Midwest, with their abandoned factories and decaying housing, are a testimonial to this destructive consequence of inflation, as is the inability of broad segments of surviving American industry to modernize to keep pace with foreign competitors. Nevertheless, despite the visible decline of the American economic system in recent decades, inflation and the nominal profits it creates make it possible for virtual hoards of the ignorant, the envious, and the downright malicious to denounce profits as excessive and to claim that they are not taxed sufficiently!
Essentially the same principles as apply to businessmen and corporations apply to lenders, who appear to be earning unprecedentedly high rates of interest and yet are being impoverished at the same time. The position of the typical creditor in a period of inflation is that after taxes are deducted from his receipt of interest, and allowance is made for the rise in prices, his real wealth—the buying power of his principal—shrinks. Anything he consumes out of his seeming income is actually at the expense of his capital.
Imagine, for example, a lender who instead of earning a 4 percent rate of interest earns a 14 percent rate of interest. However, when he earns the 14 percent rate of interest, prices are rising by 10 percent a year. In terms of buying power, this lender is no better off than he was before, despite the much higher rate of interest that he earns. Indeed, he must be substantially worse off, because out of his seeming 14 percent rate of return, he will have to pay a substantial portion in taxes. If we assume that he pays half in taxes, he is left with only a 7 percent rate of return in the face of a 10 percent rise in prices. And to whatever extent he consumes any portion of his “rate of return,” his situation is made so much the worse in terms of the preservation of the buying power of his capital.
Once more, the situation is that inflation makes the income tax operate as a tax on capital. The lender’s taxable income should begin only after allowance has been made for the maintenance of the purchasing power of his principal—viz., the portion of his interest equal to the rise in prices should not to be subject to taxation. Yet he is taxed on this portion of his income, even though it represents merely the maintenance of the purchasing power of his principal.
It should be noted that inflation produces essentially the same effect in connection with capital gains taxation, despite the fact that the rate of tax applying to capital gains may be less than the rate of income tax. For it creates capital gains all of which are required for the replacement purchase of similar capital assets at higher prices, but which are nevertheless taxed away as though they were genuine gains.
Inflation plays a major role in the decline of the highways and other socalled infrastructure of a country, which is typically maintained by the government. Government officials, usually shortsighted to begin with, rarely allow for the effects of inflation on the replacement costs of the assets they manage. Thus, as inflation pours new and additional revenues into their hands, they proceed as though the revenues were available for the expansion of government activities, and neglect the need to devote an adequate portion of them to replacement and maintenance at progressively rising prices. The result is decaying water and sewage systems, subway and rail lines, and bridges and tunnels, as well as decaying roads and highways.
The Prosperity Delusion and Overconsumption
The overstatement of income that results from inflation is the cause not only of the taxation of replacement funds, but also of excessive private consumption which comes at the expense of capital formation and which would be a serious problem even in the absence of
taxation. This overstatement represents what is often described as the prosperity delusion of inflation—the creation of an appearance of prosperity based on the mere increase in paper profits.
Our example of the machine clearly shows the nature of the problem. The stockholders and management of the company that owns that machine will believe that their firm is in a position to afford substantially increased dividends on the basis of its sharply increased profits. Years may go by before they become aware of the deficiency of replacement funds, and even then they may not realize that they had no genuine profit and should not have taken the dividends they did.
It must be stressed that overconsumption exists even if the owners of a business base their consumption entirely on their perception of their accumulated capital rather than their income, and at first save, or allow their firm to save, almost all of the additional profit that inflation generates for them. In this case, the effect of inflation will be an overstatement of their capital equal to the progressive understatement of accumulated depreciation, and thus an overconsumption corresponding to that overstatement of capital.
The problem of overconsumption is greatly compounded to the extent that there are stockholders and other business owners who are ready to use the occasion of higher profits as the basis for going on a “binge” of any sort. Inflation relaxes the normal competitive pressures of the market that constantly tend to minimize the economic influence of such people through the regular gravitation of capital and profit to those individuals who consume the least and save the most. 63 The existence of inflation represents giving people with the binge mentality a continual new lease on life. It continually provides them with the profit incomes they can use to indulge themselves.
The capital gains that inflation systematically creates in the purchase and sale of land and buildings of all kinds, and in commodity futures and common stocks, are also the source of substantial increases in consumption, as the beneficiaries of the process enjoy the apparent experience of growing richer. Inflation leads practically everyone to overconsume on the basis of the delusion of a prosperity that does not exist. Everyone who sells an asset at a higher price, such as a house or common stocks, almost certainly thinks he has gained something and can now afford to consume something he previously could not have afforded to consume. Yet, in reality, the same process that has produced his monetary gain has raised the prices of replacement assets and other goods on average to the same extent. If he consumes any part of that gain, he cannot replace the assets he has sold with comparable assets, nor maintain the buying power of his nominal wealth or capital. There is no more actual foundation for additional consumption than the fact that some extra pieces of paper have been printed in a certain way or that some bookkeeping entries have been made. 64
In some cases, indeed, individuals actually do grow richer as the result of inflation. For example, an individual who buys a $100,000 house or piece of land with a $20,000 down payment and a mortgage of $80,000, and who sells it a few years later for $200,000, makes a profit of 500 percent, since he pockets the full appreciation of the asset. Even if all other prices double along with the price of his asset, he comes out far ahead, because of the leverage of his investment.
Although the prosperity of these individuals is genuine, an overconsumption exists nonetheless, in that their gain merely represents the equivalent or even greater loss of others. For example, the individuals whose savings provided our homeowner’s mortgage have a loss at least as great as his gain. This is because when the price of the house and all other prices on average double, these individuals lose half the buying power of the $80,000 they lent him. By the same token, the $120,000 equity of the homeowner represents $60,000 of buying power in terms of the original level of prices. In other words, what inflation does is equivalent to taking $40,000 from the savers who financed the mortgage, and give it to the homeowner. It is a mere redistribution of the same total sum of existing wealth, with the homeowner-gainer then consuming a substantial portion of his gain, while no equivalent reduction in consumption takes place on the part of the saver-losers. 65
The additional consumption of the gainers from inflation is almost certain to be greater—in real terms—than the diminished consumption of the losers, because the gains go largely to people who have no special penchant for saving and providing for the future, and come at the expense of those who do. The gains from inflation come as a windfall, which the beneficiaries have not had to earn and frequently do not count very confidently on being able to keep. As a result, much of the gains are likely to be squandered. In redistributing wealth, inflation has the effect of converting previously accumulated savings and capital into an unearned current income largely of people who are bent on consumption rather than saving and provision for the future. In this way as well as others, inflation operates to raise the rate of net consumption.
In the case of a lender, it is perhaps misleading to speak of “a prosperity delusion” created by inflation, because the lender almost certainly realizes that he is falling behind. In his case, inflation serves to conceal the extent of impoverishment. It creates the illusion that in spite of his impoverishment, he still has an income, out
GOLD VERSUS INFLATION 935 of which he can afford to consume, when in actuality he does not. He would consume far less if, as in one of our previous examples, instead of having an “income” of 7 percent while prices rise by 10 percent, he had a monetary loss of 3 percent with no rise in prices, because then the true state of affairs would be real to him. He would directly perceive a loss instead of an “income” that somehow happened to be accompanied by a rise in prices of a greater magnitude but which he did not perceive as intrinsically connected.
Wage earners, too, are led to overconsume on the basis of the delusion of having higher real incomes than they actually do. In a period of inflation, with prices steadily rising, everyone has an exaggerated idea of the purchasing power of money, based on his past experience of prices, which, necessarily, is now outmoded. For example, his notion of the purchasing power of money rests in part on his estimate of the price of a new car or washing machine. But that estimate is based on his last experience of the prices of such goods, which may have occurred several months or even several years in the past, at which time the prices were undoubtedly lower than they are today. Thus, people consume in the mistaken belief that their incomes will enable them to afford to buy more than is actually possible at the now higher level of prices. In other words, they consume in the belief that they are richer than they really are, and thus on a scale that they cannot afford in their actual circumstances.
Malinvestment
In Chapter 12, I explained how in raising the rate of profit, inflation also raises the rate of interest. However, it must be kept in mind that the rise in the rate of interest tends to lag behind the rise in the rate of profit insofar as inflation enters the economic system in the form of credit expansion—i.e., the granting of new and additional loans out of the newly created money. The presence of these additional funds in the loan market prevents the rate of interest from rising as high as it would on the basis of the rise in the rate of profit alone. In the initial phase of credit expansion, the rate of interest actually falls. 66
Now the artificial rise in the rate of profit, combined with the lag in the rate of interest, leads to the wasteful investment—the malinvestment—of the reduced capital that inflation leaves still available. Projects without genuine economic merit are made to appear profitable merely by virtue of the existence of inflation, and a relatively low rate of interest ensures that capital will be diverted to them as a result. The following hypothetical examples illustrate the process.
Thus, imagine that inflation is currently raising prices on the order of 15 percent a year. Imagine further that because much of the inflation enters the economic system in the form of loanable funds, interest rates have thus far risen only to 10 percent. Now imagine a specific commodity, say, copper, whose price rises as fast as the average of prices. If the storage costs of copper are less than 5 percent a year, inflation in the form of credit expansion makes it profitable to stockpile copper—not because there is any real need to stockpile copper, but just because inflation in the form of credit expansion itself makes it profitable. (Without inflation in the form of credit expansion, the combination of storage and interest costs would make it highly unprofitable to stockpile copper, in the absence of some special, important need for copper that could not be met by future production.) Thus, copper is withdrawn from use, to be stockpiled, and labor and capital are wasted in the production of the stockpile.
This example shows how, even apart from the problems of taxation and overconsumption, inflation in the form of credit expansion makes a direct loss of wealth in an investment appear profitable all the same. For consider. Even if the price of copper rises by the same percentage as the rise in prices in general, once the storage costs are deducted from that rise, the investment in copper must entail a loss overall. If, for example, the storage costs are 3 percent a year, then the gain in money by investing in a stockpile of copper whose price rises by 15 percent, is only 12 percent. At the same time, prices in general rise on average by 15 percent. This represents a 3 percent loss in the actual buying power of the investment. But if the money for the investment can be obtained from lenders at a rate of interest of 10 percent, then the lenders suffer a loss of 5 percent in the buying power of their capital, while the borrowers, after deducting storage costs, come out with a gain equal to 2 percent of the capital invested. (The borrowers’ rate of return on their own capital depends on how highly leveraged they are. If they can borrow the entire amount, their rate of return is infinite. If they can borrow nine-tenths of the capital, their rate of return is 20 percent—viz., 2 percent on the investment as a whole, divided by the 10 percent of the total investment that they themselves put up.) In effect, the loss of the lenders covers both the loss on the investment as a whole and, at the same time, provides the source of gain for the borrowers. In other words, inflation creates a situation in which one class of investors feeds off the capital of another, while the total capital of both classes of investors combined shrinks. The rest of the economy, of course, is deprived of the benefit of capital, both the benefit of the capital that ceases to exist, because it is lost, and, to a greater or lesser extent, the benefit of the capital that is malinvested.
Similar malinvestments as occur in the stockpiling of all kinds of materials, occur in the construction of hous—
ing and plant and equipment. For example, inflation makes the price of houses rise from year to year. If the rate at which the price of houses rises is higher than the rate at which mortgage money can be borrowed—because mortgage rates are held down by the fact that much of the new money enters the economic system in the form of loans—then the purchase of houses, a consumers’ good, takes on the appearance of an investment. As a result, capital is diverted into the purchase of houses, and further capital is diverted into their construction. After purchase, the houses depreciate and suffer a corresponding loss in real value; but the losses of lenders are great enough to finance both the overall loss on the investment as a whole and a gain to the borrowers.
To use a modification of our previous example concerning housing, let us assume that while prices in general triple, the price of a given house, which grows older every year and physically depreciates, merely doubles. The overall investment in the house thus loses one-third its original buying power. Yet, if the home buyer has had to put only 20 percent of the price down, he increases his equity by a factor of 6, inasmuch as the 100 percent rise in the price of the house accrues all to him. And thus he comes out doubling his real wealth—viz., he has 6 times the equity in the face of a tripled price level. Both his gain and the overall loss on the purchase of the house are financed by the lenders, who lose two-thirds of the purchasing power of the money they lent by virtue of the tripling of prices. Using a $100,000 house for illustration, the home buyer’s equity goes from $20,000 to $120,000, while the mortgage lender’s principal does not rise above its initial $80,000. With a tripling of prices, the house, at $200,000, is worth what $66,667 was worth at the time of its purchase. The homeowner’s $120,000 equity is worth what $40,000 was worth at the time the house was purchased. The lender’s $80,000 is worth only what $26,667 was worth at the time of purchase. The loss to the lender, in terms of dollars of the original buying power, is $80,000 minus $26,667, that is, $53,333. This loss finances the loss of $33,333 on the investment as a whole in terms of dollars of the original buying power, plus the gain of the homeowner borrower of $20,000. And so it is in all cases of this kind.
The worse inflation in the form of credit expansion becomes, the worse becomes the problem of malinvestment. With a high enough rate of inflation, it may even pay to “invest” in such things as passenger automobiles, because their price as one-year-old used cars may exceed their price the year before as new cars by more than enough to cover the interest costs involved.
In order for malinvestment to occur, however, it is not necessary that inflation be strong enough to make prices actually rise or that capital be diverted into investments in which the overall rate of return is negative. As von Mises has shown, credit expansion, and the artificial reduction in the rate of interest it causes (whether that reduction is absolute or only relative to the rate of profit), creates the appearance of a more abundant supply of capital than in fact exists. That is, the mere manufacture and lending of banknotes or deposit entries does not create any actual additional capital, but only the appearance of additional capital. On the basis of this appearance, businessmen are led to undertake projects for whose execution the actual supply of capital is inadequate. Such use of capital, for purposes inappropriate to the actual supply of capital, constitutes malinvestment. Even if the use of the capital does not entail an outright loss in real terms, it still represents a diversion of capital from more important to less important uses. It is still a wasteful, inefficient use of capital, hence, malinvestment. 67
The effect of all malinvestment of capital is a reduced overall ability to produce, since the capital required for production is used inefficiently. This impairment of the ability to produce causes a reduced ability to produce capital goods no less than consumers’ goods. And this, in turn, represents a further source of diminution in the supply of capital goods in the future. Anything which, like malinvestment, impairs the ability to produce impairs the future supply of capital goods, because, as we have seen, the source of capital goods is production itself. 68
The phenomenon of malinvestment provides an important illustration of the fact that inflation does not raise all prices at the same time and to the same extent. So long as credit expansion is capable of inducing malinvestment, it tends to raise the prices of such things as storable commodities and houses relative to most other prices, by virtue of creating an artificial additional demand for them based on the desire to take advantage of the special profit that credit expansion creates in those lines. Later, when inflation in the form of credit expansion stops, slows, or simply fails to accelerate sufficiently—with the result that interest rates rise to the point of eliminating the profitability of the malinvestments—these prices fall relative to most other prices. For then the ground is cut from under the additional demand for them. This knowledge sheds important light on major movements in the commodity and real estate markets.
The Withdrawal-of-Wealth Effect
As we have seen, the very act of spending newly created fiat money or fiduciary media must inflict losses somewhere in the economic system equal to the unearned gains of the spenders. Such spending represents an uncompensated withdrawal of wealth from producers in
that the spenders draw wealth out of the system without putting wealth in. The individual businesses that receive the new and additional money may not be aware of this fact, because they can reexchange the money for the goods and service of others. But the loss must fall somewhere in the economic system. 69
The withdrawal-of-wealth effect represents a diversion of capital to consumption insofar as the spenders of the new and additional money are consumers and probable malinvestment insofar as they are business firms. The latter conclusion is implied in the fact that the firms which depend on the creation of new and additional money have proved unable to compete for capital on the regular loan market and require the subsidy that credit expansion represents.
It is almost impossible that the withdrawal-of-wealth effect could make possible an increase in capital goods at the expense of consumption, as some advocates of credit expansion have claimed in putting forward the doctrine of “forced saving.” This is because the proceeds of credit expansion are themselves largely used to finance the purchase of consumers’ goods; and of the credit expansion that is used for business purposes, a substantial portion goes for the payment of wages, which, directly or indirectly, are all or almost all consumed. Thus, it is highly unlikely that credit expansion and the withdrawal-of-wealth effect could operate as a tax on consumption in favor of capital accumulation. And when placed in the context of all the other ways that inflation and credit expansion undermine capital formation, the notion that credit expansion promotes capital formation must be judged patently absurd. 70 As we have seen, the effect of inflation and credit expansion is to increase consumption expenditure relative to productive expenditure and to increase the rate of net consumption.
6. Consequences of the Destruction of Capital
Reduction of the Real Rate of Return
All five of the effects described have been shown to operate against capital accumulation. The reversal-of-safety, tax, malinvestment, and withdrawal-of-wealth effects also operate to reduce the real rate of return on capital. The reversal-of-safety effect threatens all who invest in the traditional ways with the loss of their capital and thus with the receipt of no rate of return at all, or, indeed, a negative one. The tax effect represents the taxing away of the real rate of return. The malinvestment effect represents the investment of capital in ways that are less efficient and actually loss making. The withdrawal-of-wealth effect represents the withdrawal of wealth that constitutes part or all of firms’ real rate of return on capital.
It must be stressed that these reductions in the real rate of return occur in conjunction with less capital formation, not an abundance of capital, as the advocates of credit expansion believe. The process can be compared to the effect on the income statement of a firm, of a fire in its warehouse, or some similar calamity. It has less wealth and when it enters the reduction in its wealth on its balance sheet, it must make an equivalent charge against its income, in its income statement. Of course, none of this should really be surprising in view of the pervasive, direct and intimate relationship that we have established between aggregate profits and net investment. 71
The Gains of Debtors Less Than the Losses of Creditors
A further consequence of the undermining of capital formation, and the accompanying reduction in the real rate of return on capital, is that the gains from inflation enjoyed by debtors are less than the losses suffered by creditors. The reduction in the overall real rate of return on capital investment as such means that there is less gain for all investors combined to share. Thus, any increase in the gains enjoyed by stockholders and other classes of business debtors must be accompanied by losses on the part of bondholders and other classes of creditors that are even greater, for the latter must provide not only the gains of the stockholders and other business debtors, but also make good the reduction in the overall real rate of return on capital as such that takes place.
The phenomenon of the gain of debtors being less than the loss of creditors is obvious in the case of malinvestments that are extreme enough actually to be loss making on an overall basis, yet turn out to be of benefit to borrowers. It is particularly glaring in cases in which consumer borrowers, such as homeowners, the inherent nature of whose activity is to use up wealth, are able to increase their wealth, by virtue of having borrowed at a rate of interest that is sufficiently below the rate at which prices rise. But it is present to some substantial degree throughout the economic system, whenever credit expansion takes place. And, of course, debtors, no less than creditors, bear the full brunt of the stepped-up taxation of profits that inflation and credit expansion engender, even to the point of being deprived of any real rate of return whatever. Both categories also suffer from the inducements to overconsumption that inflation and credit expansion create.
The Impoverishment of Wage Earners
Because of inflation and the rise in consumption and accompanying undermining of saving and productive expenditure that it causes, both the relative production of capital goods and the degree of capital intensiveness in
the economic system are less. In addition, the efficiency with which existing capital goods are employed is less. All of these factors, of course, operate to reduce the supply of capital goods available for use in production. Since the productivity of labor vitally depends on the supply of capital goods, inflation operates to reduce the productivity of labor. This means, of course, that it operates to reduce real wage rates. 72
Inflation operates to reduce real wages also by virtue of the fact that real wages depend on the demand for labor relative to the demand for consumers’ goods. 73 And the demand for labor, of course, depends on saving and productive expenditure. 74 In raising the rate of net consumption and thereby retarding the growth in saving and productive expenditure relative to the growth in the demand for consumers’ goods, inflation retards the growth in the demand for labor relative to the growth in the demand for consumers’ goods, and in this way too operates to reduce real wage rates.
Thus, by virtue of its effect both on the productivity of labor and on the socalled distribution factor—viz., the demand for labor relative to the demand for consumers’ goods—inflation tends to make prices rise at a more rapid rate than wage rates and thus to bring about a corresponding reduction in real wage rates.
It is important to realize that insofar as the government and labor unions attempt to resist the tendency toward the fall in real wages, by forcing wage rates to increase as fast as prices, the effect of their action is to cause unemployment. Insofar as prices rise because of a decline in the productivity of labor or because of a growth in the demand for consumers’ goods in excess of the growth in the demand for labor, any attempt to make wage rates rise equivalently is an attempt to make them rise without benefit of a rise in the demand for labor. This is an important, though not the most important, way in which inflation actually causes unemployment rather than prevents or remedies it.
The Stock Market and Inflationary Depression
The fact that inflation undermines capital formation has important implications for the performance of the stock market. In its initial phase or when it undergoes a sufficient and relatively unanticipated acceleration, inflation in the form of credit expansion can create a stock-market boom. However, its longer-run effects are very different. The demand for common stocks depends on the availability of savings. In causing savings to fail to keep pace with the growth in the demand for consumers’ goods, inflation tends to prevent stock prices, as well as wage rates, from keeping pace with the rise in the prices of consumers’ goods.
The same consequence results from the fact that inflation also leads to funds being more urgently required internally by firms—to compensate for all the ways in which it causes replacement funds to become inadequate. At some point in an inflation, business firms that are normally suppliers of funds to the credit markets—in the form of time deposits, the purchase of commercial paper, the extension of receivables credit, and the like—are forced to retrench and, indeed, even to become demanders of loanable funds, in order to meet the needs of their own, internal operations. The effect of this is to reduce the availability of funds with which stocks can be purchased, and thus to cause stock prices to fall, or at least to lag all the more behind the prices of consumers’ goods.
When this situation exists in a pronounced form, it constitutes what has come to be called an “inflationary depression.” This is a state of affairs characterized by a still rapidly expanding quantity of money and rising prices and, at the same time, by an acute scarcity of capital funds. The scarcity of capital funds is manifested not only in badly lagging, or actually declining, securities markets but also in a socalled credit crunch, i.e., a situation in which loanable funds become difficult or impossible to obtain. The result is widespread insolvencies and bankruptcies.
7. Inflation as the Cause of Depressions and Deflation
Inflation, especially in the form of credit expansion, sets the stage for financial contractions and deflations— i.e., for depressions. It does so in several, related ways.
It undermines the perceived need and the desire to own money balances. As a result, it causes a more rapid spending of money—a rise in the socalled velocity of circulation of money. An integral part of this process, of course, is a growing state of financial illiquidity—a declining ratio of cash holdings to current liabilities.
These results occur in large part because credit expansion creates the prospect of being able to obtain the money needed to make purchases and pay bills, easily and profitably through borrowing. The prospect of loans manufactured out of thin air by the banking system is substituted for the holding of actual money, with the result that businesses are led to draw down their cash reserves in making loans and investments they otherwise would not have made. 75 For they expect that when they need money they can readily obtain it from their banks. The fact that credit expansion, and the creation of money in any other form, causes the demand for goods and services to grow makes the holding of additional inventories also appear as a welcome substitute for the holding of money as the means of assuring the ability to make purchases and pay bills in the future, since in a rising market the inventories can be liquidated all the more
easily and profitably.
These mechanisms are reinforced by the fact that after a while, inflation—even in the form of credit expansion—raises interest rates. This, of course, makes it worthwhile for people to lend out shortterm sums of money that it otherwise would not have been worthwhile to lend out and would thus have remained in cash holdings. Finally, as inflation proceeds to the point of raising prices, people sooner or later become accustomed to the rise in prices and come to expect them to go on rising. When this happens, they start buying sooner, before prices rise further.
In all of these ways, inflation of the money supply brings about an even greater increase—a superinflation, as it were—in the volume of spending in the economic system, and a corresponding diminution in the size of cash holdings relative to spending and to current liabilities. Spending rises not only because there is more money, but also because the increase in the quantity of money reduces the perceived need and hence the desire to own money. 76
The other side of spending, of course, is people’s revenues and incomes, since one man’s spending is another man’s receipts. Obviously, in superinflating the volume of spending in the economy, inflation also superinflates people’s revenues and incomes.
Inflation also does something else. It encourages people to pile up a mass of debt that they can pay only so long as their revenues and incomes hold up—indeed, only so long as their revenues and incomes go on increasing. Inflation in the form of credit expansion encourages borrowing by holding down the rate of interest in relation to the rate of profit. It makes borrowing exceptionally profitable; and the more so, the more leverage the borrowing provides. Another important way that inflation encourages debt is simply by leading people to borrow in anticipation of rising prices. Housing purchases have been a prime example of this effect of inflation. People go heavily into debt to buy houses at already inflated prices, because they expect housing prices to go on rising. The same thing happens with business spending for plant and equipment and inventories.
Thus, inflation does two critical things. It superinflates people’s revenues and incomes, while making them correspondingly illiquid, and it leads them to pile up substantial debts against those revenues and incomes.
This alone must set the stage for a depression if and when inflation stops. Because then the causes of the reduced demand for money balances are removed. At that point, people start trying to rebuild their cash holdings. As a result, spending and the velocity of circulation fall, with the further result that people’s money revenues and incomes fall. The effect of this, in turn, is that they cannot pay their debts. A substantial number of business and personal bankruptcies occurs.
The consequence of this, of course, is that the assets and capital of banks which have lent to such borrowers is correspondingly reduced, and many of them also fail. The failure of banks, of course, causes the money supply actually to be reduced, since the banks’ outstanding checking deposits are part of the money supply. The reduction in the money supply then leads to a further decline in spending, revenue and income, and thus to still more bankruptcies and bank failures. The process feeds on itself, potentially to the point of eliminating all fiduciary media from the money supply and making the money supply equivalent to the supply of standard money alone. 77 The reduction in the quantity of money can be avoided only if the government is prepared to create additional fiat standard money to whatever extent may be necessary to guarantee the fiduciary media of the failing banks. But this lays the foundation for a still greater expansion in the supply of fiduciary media in the future.
This is the essence of the inflation-depression process. The critical factors are: artificial inducements to illiquidity and to a corresponding superinflation of revenues and incomes; the piling up of a mass of debt against these superinflated revenues and incomes; and then a contraction in spending, revenues, and incomes following the end of the inflation. The contraction phase leaves people with no means of paying the mass of debt they have accumulated, and can operate to produce a self-reinforcing downward spiral of deflation of the money supply.
The inflation-depression process is reinforced by the fact that inflation in the form of credit expansion causes malinvestments—investments which are profitable only on the basis of inflation itself. When the inflation comes to an end, the unprofitability of the malinvestments is revealed.
The onset of the depression is precipitated by the fact that inflation and credit expansion undermine the availability of real capital and thus of credit, too, in real terms. In particular, when credit expansion stops, a “credit crunch” develops. This is because the existing capital funds of many enterprises are made inadequate by the rise in wage rates and materials prices caused by the previous injections of credit in the form of new and additional money. The consequence is that firms requiring credit turn out to need more credit than they had planned on, while those firms normally supplying credit turn out to be able to supply less than had been counted on, and may even need credit themselves in order to meet the requirements of their own internal operations at these higher wage rates and prices. Thus, as the need for credit surges and as suppliers of funds become demanders of
funds, or at least supply less funds, firms that had counted on borrowing money, or on refinancing their existing borrowings, find that they are unable to do so. This causes insolvencies and bankruptcies. In this environment, as it becomes clear that the funds one had been counting on from others are not available, people’s demand for holdings of money rises: it becomes necessary to liquidate inventories and other assets and to curtail expenditures, in order to have the funds available to meet one’s obligations. In this way, the “velocity of circulation of money” falls.
These results can occur not only when inflation stops, but also when it merely slows down or even when it fails to accelerate sufficiently. To postpone the onset of a credit crunch, it becomes necessary to provide the victims of previous credit expansion with additional funds, in order for them to be able to pay the higher wage rates and materials prices caused by the previous credit expansion. Then still further inflation and credit expansion become necessary in order to overcome the resulting inadequacy of the funds of still others, possibly including the funds of the initial recipients of credit expansion, who perhaps are now themselves faced with unexpected increases in wage rates and materials prices. If at any point, the necessary additional credit expansion is not forthcoming, a credit crunch develops. If it is forthcoming, people soon begin to borrow on a larger scale, in anticipation of the possible inadequacy of funds in the face of higher wage rates and materials prices. If that additional demand for loanable funds is not met by still more credit expansion, the result is a credit crunch at that point. If it is met by still more credit expansion, the result is a still greater increase in wage rates and materials prices, which nullifies the value of the greater borrowing and requires still more credit expansion to avoid the onset of a credit crunch. Whenever the necessary additional credit expansion is not forthcoming, some firms find that they lack the funds they require, and thus a credit crunch develops.
The failure of inflation to accelerate sufficiently can also cause the demand for money for holding to increase, and thus velocity to decrease, insofar as the demand for money for holding has become unduly low based on the expectation of a more rapid acceleration of inflation than turns out to be the case. This consideration is relevant to the fall in the velocity of circulation that took place in the United States in the early 1980s. By the beginning of the 1980s, the height of the velocity of circulation corresponded to a growing expectation that the U.S. government would begin to inflate on a scale characteristic of Latin American countries. When the rate of inflation turned out to be much more modest, the demand for holdings of money increased in the United States, and thus the velocity of circulation fell.
Finally, it should be realized that in order to produce a “credit crunch” and the onset of a depression, it is not necessary that credit expansion result in an actual rise in wage rates and materials prices. It is necessary only—as is inescapable—that it make wage rates and materials prices higher than they would otherwise have been. If wage rates and materials prices fail to fall, or fall by less than they would otherwise have done, the effect is still to render existing capital funds less adequate than they would otherwise have been and to create a need for more capital funds than would otherwise have been the case. As a result, in this case too, firms that would have been suppliers of capital funds in the loan market must become smaller suppliers, or even demanders of such funds. Thus, the basis is still present for the unexpected deficiency of credit that characterizes a credit crunch. These considerations are of great importance in considering the 1929 Depression, which came after a decade of relatively stable or even modestly declining commodity prices.
Gold Clauses and Prospective Inflation of Paper as the Cause of Deflation in Gold
It may help to shed light on the Great Depression of the 1930s to realize that there are circumstances in which the prospect of inflation can have the seemingly paradoxical effect of producing an immediate deflation. This is the case when the prospect of inflation takes place under a fractional-reserve gold standard, such as existed in the early 1930s, and at the same time the great bulk of debt contracts contain gold clauses. (Gold clauses define debts in terms of the obligation to pay a definite sum of gold. For example, prior to April 1933, the obligation to pay $2,000 actually meant, according to most debt contracts in force in the United States, the obligation to pay approximately 100 ounces of gold, for it was explicitly stated that the dollars in the contracts were to be understood as representing gold at the rate of one ounce for every $20.67.)
In such circumstances, whenever inflation causes a devaluation of the paper money against gold to a greater extent than the increase in the quantity of paper money, it reduces the ability of the paper money supply to pay debts in gold. In this sense, it constitutes a deflation. For example, if initially there are $20 billion of paper money (including checkbook money) in existence in the United States, and these $20 billion are convertible into gold, on demand, at $20 per ounce, then this supply of paper is the equivalent of a billion ounces of gold. (Under a fractional-reserve gold standard, of course, there will not actually be a billion physical ounces of gold, backing the $20 billion of paper, but only some fraction of this physical amount. However, the supply of paper money
is the equivalent of a billion ounces of gold in terms of current debt-paying power, so long as it is freely convertible into gold on demand at $20 per ounce.)
If now, however, as the result of prospective inflation, and of the government’s refusal to redeem the paper money for gold on demand, the price of gold were to rise, say, to $40 per ounce, then the $20 billion of paper would be devalued to the equivalent of only half a billion ounces of gold. If we view the supply of paper money not as a supply of “dollars,” but as a supply of equivalents of gold ounces, then our assumed devaluation represents a halving of the money supply insofar as the money supply is composed of paper. For the paper money supply was a billion “gold-ounce equivalents,” and now it is only half a billion “gold-ounce equivalents.” 78 Such a devaluation would mean radically reduced “gold-ounce” sales revenues, while “gold-ounce” principal and interest charges remained the same. The prospect of such a devaluation must obviously mean the prospect of mass bankruptcies.
The prospect of such a devaluation and of its resulting mass bankruptcies must precipitate immediate bankruptcies, for lenders with funds coming due will not reextend credit in an environment in which its later repayment is made unlikely. Widespread immediate bankruptcies, of course, precipitate bank failures and a decline in the outstanding quantity of money. What is present here can be described as the prospect of future bad money driving present relatively good money out of existence.
On the basis of these considerations, I advance the hypothesis that the depression of the 1930s was intensified by the Federal Reserve’s efforts to expand the quantity of money in order to reduce interest rates and finance largescale government budget deficits. These efforts had the effect of creating the prospect of a devaluation of the dollar against gold and thus of making the honoring of gold-clause contracts correspondingly more difficult, with the result that they precipitated greater credit contraction and thus a larger number of immediate bankruptcies and bank failures, and, because of this last, a decline in the quantity of money. Seen in this light, the budget deficits of the Hoover administration must be regarded as profoundly and radically deflationary insofar as their financing necessitated the Federal Reserve’s efforts to expand the supply of paper dollars and thereby threaten their gold value. By the same token, Roosevelt’s 1932 campaign promise of reducing federal spending by 25 percent and balancing the budget turns out, had it been put into actual practice, to be exactly the right prescription for combatting deflation.
I hypothesize also that the policy of inflation which was pursued around the world, and the consequent devaluation of gold-standard currencies, was responsible for the radical reduction in the volume of international trade which took place in the 1930s. For international trade had been conducted in gold or currencies regarded as equivalent to gold. This policy radically reduced the world supply of money when viewed as gold equivalents. In thus reducing the supply of internationally useable money, it reduced the volume of international trade.
(The principles present in this discussion apply to the devaluation of any currency in a situation in which substantial debts are payable in a different currency. For example, if an inflation of Mexican pesos precipitates a devaluation of the Mexican peso against the American dollar to a greater degree than the increase in the supply of pesos and spending in terms of pesos, while Mexicans owe substantial debts payable in dollars, the effect of the inflation of pesos is deflationary from the perspective of the ability of Mexicans to pay debts denominated in dollars. In the same way, the mere prospect of such a devaluation can render the Mexican government’s policy of inflation deflationary from its very inception.)
8. Inflation as the Cause of Mass Unemployment
The fall in spending that takes place in the course of a depression causes mass unemployment, unless and until wage rates fall to the point of permitting the consequently reduced payroll funds to employ all who are able and willing to work. Since it is inflation that sets the stage for depressions, it is inflation that is responsible for the unemployment that accompanies them. In the absence of inflation and credit expansion, there would be no depressions and thus none of the mass unemployment that takes place in depressions, because the preconditions for a depression would simply not come into existence. 79
Given the existence of inflation, it is true that its continuation and acceleration can forestall the development of mass unemployment. But this no more makes inflation a means of preventing unemployment than narcotics are a means of preventing sickness and debilitation. The temporarily preventative effects both of inflation and of narcotics exist only in a context in which their prior use has created a dependency on them. Had they not been resorted to in the first place, the dependency would not exist. Stop their use, and after a painful interlude, the dependency disappears. And their use must be stopped, if utter destruction is not to result. When their use is stopped, it is their use, not the stoppage of their use, which must take the blame for the resulting mass unemployment in the one case and for the withdrawal symptoms in the other.
As we have seen, in the face of the existence of strong monopoly labor unions, inflation is ineffectual as a remedy for existing unemployment. For the unions will seize the opportunity of rising aggregate demand to raise wage
rates even in the midst of mass unemployment, and will thus prevent the growth in payroll funds from being accompanied by anything near a corresponding growth in the number of workers employed. 80 And, it should be recalled, those who are reemployed on the various make-work projects that almost always accompany any attempt to eliminate unemployment by means of inflation, are employed at a loss to the rest of the population, which must provide them with goods and services and receive nothing of corresponding value in return. 81 On the other hand, in the absence of substantial monopoly labor unions, wage rates are free to fall and unemployment can be eliminated in this way.
There is only one case in which any kind of plausible argument can be made in favor of inflation as a remedy for existing unemployment. This is when a financial contraction/deflation has begun and in which no substantial downward adjustment of prices and wages has yet been made, and when there either are no substantial monopoly labor unions or, if there are, they are weakened to the point that they will not use the occasion of a rising aggregate demand to force up wage rates significantly. In this case, inflation, or more correctly the resumption of inflation, constitutes a restoration of the status quo ante, as it were, and is capable of achieving substantial reemployment. The conditions of this case appear to have been present in recessions in the United States since the early 1980s.
Even in this case, however, the essential problem remains that the policy of inflation continues, and with it, all of its destructive consequences. And to the extent that people come to expect that inflation will be resumed in such conditions, the effect is to prevent the downward adjustment of prices and wages that would eliminate the unemployment without any resumption of inflation. What occurs is nothing more than that the withdrawal symptoms are overcome by resuming the destructive narcotic, and the knowledge that the inflation narcotic is available prevents any step toward really solving the problem.
The government’s readiness to resort to a resumption of inflation as the means of combatting unemployment guarantees the continuation of inflation with only the most minor of interruptions. Inflation goes on both when unemployment is a problem and when it is not a problem. It sets the stage for a financial contraction/deflation and thus mass unemployment as soon as the government makes any serious effort to stop or reduce it, and then, because of this, no sooner does the government make such an effort than it comes under mounting pressure to abandon it and return to its policy of inflation. If inflation is ever to be eliminated, the government must lose the power to inflate even in conditions in which doing so can reduce unemployment. Unemployment must be eliminated through a fall in wage rates and prices. 82
Sooner or later, of course, even in the midst of continuing and accelerating inflation, substantial unemployment develops in any case. It occurs because of the tendency of real wage rates to fall as the result of inflation and because of efforts to prevent this fall by forcing wage rates to rise fully as rapidly as prices, without benefit of the necessary increase in the demand for labor. 83 Even more important is the fact that as inflation becomes more extreme, the potential for sudden mass unemployment is created by efforts merely to moderate the inflation, and even by the failure sufficiently to accelerate it.
For example, if the quantity of money and aggregate demand have been growing rapidly enough to raise wages and prices, say, by 50 percent a year, and the government decides that it wants to moderate the inflation to the point that wages and prices rise only by 25 percent a year, its action is capable of causing mass unemployment. This will occur simply by virtue of wages and prices continuing to rise for a time at their previous rate, on the basis of sheer inertia, as it were. In the face of a relatively “modest” 25 percent rise in the demands for consumers’ goods and labor, the effect of increases in the price and wage level temporarily continuing at a 50 percent rate is a one-sixth decline in the quantity of consumers’ goods purchased and a one-sixth decline in the number of workers employed. This is because 5 ⁄ 4 times the demand, when divided by 6 ⁄ 4 times the price or wage level, can purchase only 5 ⁄ 6 times the quantities.
Similarly, in conditions in which the rise in prices and wages discounts a substantial acceleration in the increase in aggregate demand that fails to materialize, mass unemployment will result. For example, if aggregate demand has been growing at a 50 percent annual rate and wages and prices begin to rise at a 75 percent annual rate, in anticipation of aggregate demand growing at 75 percent, and then aggregate demand fails to grow more than 50 percent, a comparable degree of unemployment will be created. The same kind of results occur, of course, in conditions in which the demand for money for holding has fallen in anticipation of a degree of inflation that does not materialize, which then leads to a rise in the demand for money for holding. A situation describable by one or more of these three patterns of the development of mass unemployment in the midst of inflation occurred, for example, in Uruguay in the late 1960s, when the unemployment rate reached 28 percent at the same time that prices were rising at an annual rate of 61 percent. 84
9. The Inherent Accelerative Tendencies of Inflation
The potentially most devastating consequence of inflation is that, once begun, the process tends to acceler—
ate. The ultimate stopping point of the acceleration is that the inflated currency loses its acceptability. This occurs when people realize that between the time they accept it and even the earliest possible time they can spend it and thus pass it on to someone else, they will have suffered a substantial loss in buying power. At that point, they refuse any longer to accept it in exchange for their goods and services, and turn instead to barter if necessary. The inflated currency loses its character as money and ends up being dumped in the streets and down the sewers, as just so much litter.
In his seminar, von Mises used to describe the acceleration of inflation as going through three phases. In the first phase, people observe that prices are rising but still believe that the rise is temporary. They are willing to increase their holdings of money, in the conviction that prices will one day come down. In the second phase, people have come to the conclusion that prices will never come down, but will go on rising. In this phase, their attitude is described by the man who says, “I do not need a new refrigerator this year, but I will need one next year. I will buy it this year, however, in order to avoid having to pay a higher price for it next year.” In the third and final phase of inflation, the attitude of people is described by the man who says, “I do not need a new refrigerator now and never expect to need one, but I will buy one nonetheless, because it is better to own anything than this rapidly depreciating money.” This last phase represents what is described as the “flight into real values.” 85
Inflation tends to accelerate for a variety of reasons. One is that the underlying premises which lead to the policy of inflation in the first place—namely, the alleged helplessness of the individual and the alleged omnipotence and benevolence of the government—logically call for more and more rapid inflation as time goes on. As we shall see, two factors closely related to this are that inflation itself creates problems whose solution is perceived as requiring still more inflation, and that the stimulative effects of any given rate of inflation tend to wear off and to require a more rapid rate of inflation to maintain them.
Both of these phenomena are present in the very fact that inflation tends to raise the velocity of circulation. So long as the velocity of circulation is rising, the rate of increase in the volume of spending in the economic system is greater than the rate of increase in the quantity of money. But once the velocity of circulation stabilizes at any given higher level, the rate of increase in the volume of spending necessarily falls to that of the rate of increase in the quantity of money alone. To maintain the previously higher rate of increase in the volume of spending, a more rapid rate of increase in the quantity of money is now necessary, which, in turn, tends to be accompanied by a still higher velocity of circulation of money, leading, of course, to the same result and the need for a still more rapid increase in the quantity of money later on. In addition, as the result of any stabilization of velocity after a sustained period of rise, the rate of profit is almost certain to fall, inasmuch as it will now reflect a lesser rate of increase in spending. Its fall, furthermore, operates to diminish the gains inflation provides to stockholders and other business debtors at the expense of bondholders and other business creditors. These gains meanwhile are also tending to be reduced by a rise in the rate of interest toward any given rate of profit. 86 Thus, an acceleration of inflation is called for to maintain the rate of profit, and a more rapid acceleration to maintain any given ratio of excess of the rate of profit relative to the rate of interest. These accelerations must be indefinitely repeated if the rate of profit is not to be allowed to fall and if its relationship to the rate of interest is to be maintained.
Of course, there is nothing inevitable in the acceleration of inflation. It can be interrupted; indeed, inflation can be stopped altogether. But in order to do either of these things, the willingness must exist to bear the temporary painful consequences. The accelerative tendencies of inflation all come down to the fact that there are such consequences. If the willingness to bear them is lacking, then inflation can be presumed continually to accelerate.
The Welfare-State Mentality
The logic of the welfare-state mentality is capable all by itself of resulting in unlimited inflation. If it is believed that the government is a real-life Santa Claus, indeed, a benevolent deity, and that its inflation-financed deficits are the source of free benefits, then there is no logical stopping point to the size of the deficits and the amount of the inflation used to finance them—given the fact that the government has the power to inflate.
If, for example, it is believed that the government has the power to provide free high-school education, then why not free college education? If it has the power to provide free medical care to people over sixty-five years of age, then why not to everyone? If it has the power to provide some people with lowcost housing, then why not more people?—why not everyone? If it can make it possible for people to retire at age sixty-five, then why not at age sixty, or even fifty-five?
Even under the Reagan administration, which appeared to manifest a substantial opposition to further growth of the welfare state, the corrupting influence of the ability to inflate never diminished. On the contrary, it thoroughly undermined efforts to end the growth of the welfare state and turned the desire for lower taxes and a stronger national defense into causes of more rapid infla—
tion. The Reagan administration, at least in its early years, rightly regarded the proper function of the federal government as that of providing national defense, not public welfare. It espoused a philosophy of limited government and low taxes. Yet the government’s ability to inflate made it possible to increase the defense budget and lower taxes without making any reduction whatever in the amount of welfare state spending. The result was that the Reagan administration simply added its increase in the defense budget, and its tax reductions, to a still growing level of welfare-state spending, and produced unprecedented peacetime budget deficits. These deficits required and received the support of very high rates of inflation—for example, a 16.9 percent increase in the money supply in 1986, following an 11.1 percent increase in the money supply in 1985. 87
Throughout the Reagan years, the premise persisted that there is no limit to what the government can accomplish, if only it is willing to spend enough money. The great majority of people continued to believe all along that an economically insignificant city—Washington— which is utterly lacking in industry and is not a center of commerce or the performance of any other economic service, is nevertheless somehow capable of “bailing out” the economic system. “Washington” was and is thought to be capable of rescuing major companies and entire industries and undertaking the economic redevelopment of such major cities as New York, Philadelphia, Detroit, and Cleveland, and even that of whole states and entire geographic regions.
Nothing could be better evidence of the delusion inflation fosters, that it is the government that supports the people instead of the people who support the government, than the prevalence of such beliefs. “Washington” is seen as capable of achieving all these miracles for the simple reason that its ability to inflate allows it to spend money without first having to collect that money from the people. If not for this, it would be obvious that “Washington” can give nothing that it does not first take away, and thus, whenever it acts to help any individual or group, it is intensifying the hardship of other individuals and groups, and, indeed, causing losses substantially greater than any gains it may provide. For it not only takes from A to give to B, but in the process it reduces the incentive and the ability to produce.
Whatever the opposing influence of the Reagan administration, the welfare-state mentality has now been reenthroned. In the midst of massive budget deficits, and the shedding of rivers of crocodile tears over them, the last few Congresses have busied themselves with such measures as expanding the medicare system and embarking on federal support for child-care facilities. And, not very long ago, the administration of President Clinton was narrowly prevented from imposing a vast increase in government financing of medical expenses, which, had it been enacted, would almost certainly have turned out to be greater in cost than any new government program since social security.
Inflation to Solve Problems Caused by Inflation
The expressions “bail out” and “rescue” suggest what is perhaps the most important reason that inflation tends to accelerate. This is the fact that the very destruction and suffering that inflation causes makes still more inflation seem necessary and desirable. Inflation becomes the means of alleviating the consequences of inflation. It is a tool, an evil, destructive tool, but one whose immediate, visible effects for the user and for the groups on whose behalf it is used seem desirable. Thus, the more and the greater are the problems it creates, the more it tends to be used. Again, the analogy to drugs is very apt. Someone begins taking drugs as a means of alleviating his feelings of inadequacy. The effect of the drugs is soon to make him feel still more inadequate. And the apparent solution is then to increase the dosage.
The fact that major cities and industries need “bailing out”—which, of course, the government would finance largely on the basis of an increase in the quantity of money—is itself mainly the result of years of inflation and the consequent systematic overstatement of profits, leading to the taxation and consumption of funds required for the replacement of assets. It is a consequence of all of the destructive effects of inflation on saving and capital formation. Similarly, demands for ever more government aid to the elderly, and the inflation that must be resorted to in order to finance those demands, are largely the product of previous inflation, which has wiped out the value of pensions and savings. In the same way, demands for government support of the home-mortgage market, and the inflation required to finance it, are the result of the destruction of mortgage credit brought about by previous inflation.
When inflation goes far enough actually to reduce the ability to produce, the real revenues of the government begin to decline. This, together with the increasing demands being made upon the government as the result of the same process of economic decline, almost inevitably results in a still further acceleration of inflation.
The apparent need to inflate is further compounded to the degree that the rise in prices reaches the point of substantially reducing the buying power of the government’s tax collections, which are largely based on incomes and transactions of the recent past. The more rapid the rise in prices, the greater is the reduction in the buying power of such tax receipts, and thus the greater the apparent need of the government to rely still more heav—
ily on the printing press as the source of its funds. And, as previously pointed out, the apparent need to inflate is greatly increased when the day comes that private investors reach the conclusion that they must lose by purchasing government securities, and thus stop doing so, leaving the government’s printing presses to make up for their withdrawal. 88
The government is motivated to accelerate inflation not only for all of the above reasons, but, of course, also to paper over developing “credit crunches” as well as to overcome the previously described “profit squeezes” that must result from the stabilization of the velocity of money at any given higher level. 89
Recessions as Inflationary Fueling Periods
Paradoxically, given the ability to inflate, even government efforts to end or reduce inflation can serve to accelerate it. The government begins by cutting back on inflation. But then a recession develops: insolvencies and bankruptcies appear; unemployment starts to increase. Now the government becomes frightened. Before the recession goes too far and turns into a full-scale depression, it reverses itself and accelerates the inflation. As a result, cash holdings relative to spending are built up on the basis of newly created money rather than on the basis of a decline in spending. At the same time, the injection of the new and additional money brings an end to the insolvencies and bankruptcies and mounting unemployment. Finally, once it is recognized that the danger of a depression has passed and that the policy of inflation is back in place, the money created to turn the recession around comes pouring out into the spending stream. In this way, even recessions end up serving as inflationary fueling periods.
Indexing and the Wage and Interest Ratchets
As people become aware of the consequences of inflation, they take steps to protect themselves. The use of price indexes is one very popular method.
It should be realized that price indexing does not provide any means for dealing with the problem of lags between the rise in the prices one must pay and the prices or income that one receives. At most it can enable an individual to catch up with the rise in prices. But it does not compensate people for the loss of purchasing power they experience in the intervals before catching up. Moreover, the widespread use of indexing, by operating to make prices rise automatically by the same percentage, undermines the functioning of the price system, which depends precisely on the unevenness of price changes.
Despite their shortcomings, inflation spawns the use of price indexes. They appear more and more in employment contracts, where they require periodic increases in wages in line with the rise in prices. Some years ago in the United States, social security payments became tied to a cost-of-living index. More recently, income tax brackets have been tied to the movement of prices: to the extent that the rise in individuals’ incomes does not exceed the percentage by which prices rise, their tax bracket will not be increased. In the years ahead, it is possible that depreciation allowances will be tied to a price index. The payment of interest on government bonds and the computation of interest income for tax purposes might also some day include adjustments for the rise in prices.
All of these measures of protection against the effects of inflation tend to accelerate inflation, by creating further problems whose solution appears to be still more inflation. For example, to the extent that wages are increased merely because prices rise, that is, in the face of a given demand for labor, unemployment tends to develop. If the government wishes to avoid the unemployment that wage indexing can cause, then it must see to it that the wage increases are accompanied by further increases in the quantity of money. In that case, wages can increase and the increases can be passed along in the form of further price increases, which then serve as the basis for further wage increases. By providing the money to accommodate a wage-price spiral, the government can be led into an extreme and rapidly accelerating inflation—at each step pouring ever more money into the market in order to avoid the unemployment that would result from not accommodating the wage-price spiral. This has been the situation in Israel and Argentina and many other countries.
The indexation of the government’s expenditures, such as social security payments, and the indexation of its tax revenues, operate to enlarge its expenditures and reduce its revenues. The result is a tendency toward greater deficits and thus more rapid creation of money to finance the deficits.
Even apart from wage indexing, there is a powerful tendency for inflation to accelerate in the government’s efforts to avoid unemployment. For example, the labor unions may begin very modestly—seeking to raise wages by, say, a mere 2 percent above the level a free market would provide. The effect of their action is either the development of an addition of roughly 2 percent to the unemployment rate or to lead the government to choose to increase the quantity of money by an additional 2 percent, to make the demand for labor keep pace with the rise in wage rates.
If, as is likely, the government chooses to increase the quantity of money by an extra 2 percent, then no additional unemployment develops, but prices rise by an additional 2 percent. The unions now feel cheated. Their
wage increase in the previous year has been eaten up by price increases. Perhaps for a number of years they will continue to ask for just an additional 2 percent. If so, the same story will continually repeat itself. Sooner or later, however, the unions will come to take a 2 percent rise in prices for granted. At that point, in order to obtain a 2 percent real improvement, they will begin to ask for wage increases of 4 percent. If the government increases the quantity of money sufficiently to accommodate this higher rate of wage increase, then additional unemployment will again be avoided, but now prices will begin to rise on the order of 4 percent a year instead of just 2 percent a year.
Once again, the scenario may be repeated several times. But eventually, the unions will conclude that prices can be expected to rise by 4 percent a year, and that in order to obtain a gain in real wages of 2 percent, they must demand wage increases of 6 percent. If the government continues to accommodate the unions by increasing the quantity of money more rapidly, their wage demands will rise to 8 percent, then 10 percent, and so on. In a word, there is an upward ratcheting of wage demands, with each higher level of wage demands (provided it is accompanied by the necessary increase in the quantity of money) serving to establish a higher level of increase in prices, on the basis of which wage demands are raised further.
At some point along the way, a process that can be described as double discounting emerges. The unions conclude that prices will not rise merely at some given rate, but can be expected to rise at an increasing rate. At this point, in order to obtain whatever increase in real wages they are after, they begin to demand wage increases equal not only to the rate at which prices have been rising up to now, plus the real improvement they seek, but wage increases equal to the higher rate at which they expect prices to rise over the life of their employment contracts, plus the real improvement they seek. This represents an acceleration in the acceleration of wage and price increases. And from here, still further acceleration in the acceleration develops, as expectations concerning the rate of acceleration start to increase. Thus, wage demands of 4 percent over the previous rise in prices are appropriate as a means of seeking a 2 percent real improvement only if the rate of price increases advances at 2 percent a year. But now, as the result of the demands for more rapid wage increases (always assuming, of course, accommodation by a more rapidly increasing quantity of money), prices will begin to rise with an acceleration of 4 percent a year instead of just 2 percent a year. Soon the unions will take such acceleration for granted and begin to accelerate their wage demands by 6 percent, then 8 percent, and so on. And thus, wages and prices begin skyrocketing upwards—10 percent a year, 14 percent a year, 20 percent a year, 28 percent a year, and on and on.
A similar process of upward ratcheting and acceleration takes place in connection with interest rates. The rise in prices that inflation causes reduces the real rate of interest received by creditors. In order for lending to be worthwhile, creditors need to receive higher rates of interest, which reflect the rate at which prices rise. But, as we have seen, no sooner do creditors begin to receive such rates of interest, than the special profit inflation provides to borrowers is removed. Moreover, inflation makes it a matter of virtual self-preservation for borrowers to gain at the expense of lenders, because if they do not, then, on an aftertax basis, their incomes cannot possibly keep pace with the rise in the replacement prices of their assets. 90 As a result, the borrowers find the rise in interest rates oppressive and demand a more rapid rate of inflation and credit expansion, both to reduce interest rates and to provide the revenues and profits with which to make any given level of interest rates payable. This problem becomes more intense, the greater inflation becomes, because the overall real rate of return on capital as such is all the more reduced, making the plight of the borrowers correspondingly more desperate in the absence of an ability to be compensated at the expense of the lenders. 91
A succession of rounds of rising inflation and rising interest rates to compensate the creditors may ensue. But each time, the higher level of interest rates turns out to be inadequate in the face of still more rapidly rising prices. Finally, the day arrives when creditors conclude that no rate of interest, however high, will protect them, because the rate of price increase will be still higher. At that point, all private credit begins to disappear. Private citizens stop lending not only to the government but also to each other. At this juncture, a great quantum leap in the rate of inflation can easily take place. For the government may now attempt to replace the dwindling supply of private credit, provided out of savings, with credit provided out of newly created money. Indeed, this phenomenon exists, though on a comparatively small scale, as soon as any of the citizens become aware of what is happening and therefore cease to lend money. From this time on, there is a reduction in the supply of loanable funds that the government is motivated to make up for through policies of more rapid inflation.
The Current State of Inflation
As I have indicated, all of the above forces operating to cause inflation to accelerate are tendencies. Like anything else that is subject to human choice, their operation is not absolutely inevitable or inescapable, and certainly
not in any given short period of time. Their presence very well describes the period 1933-1980 in the United States. In 1981 and 1982, however, the U.S. government refused to provide the accelerated increase in the quantity of money that the markets had come to expect it to provide. 92 Instead, it inaugurated a prolonged and severe recession—some would say the first depression since the 1930s. It allowed unemployment to increase and bankruptcies to occur to the point where people gave up the expectation of rapidly accelerating inflation and became willing to sell their goods and services at much lower rates of price increase than had prevailed before. Hence, the conviction developed that inflation was now “under control.”
The result of the government’s action in those years was actually to create a good deal of deflationary psychology. Many people came to fear that the legacy of enormous debt burdens and illiquidity left by inflation would drag the economic system into a sharp contraction of spending and successive waves of bankruptcies and bank failures, which the government would be powerless to stop. And, in truth, it must be admitted that major deflationary potential has existed and really does exist in the economic system. The collapse of real estate prices, the resulting failure of large numbers of savings and loan associations and savings banks, whose major asset was real estate loans, and the resulting virtual bankruptcy of the Federal Savings and Loan Insurance Corporation, all provide ample evidence of this. Further and even stronger evidence was provided by the precarious condition of many commercial banks and the virtual exhaustion of the resources of the Federal Deposit Insurance Corporation.
If, however, anything that is subject to human choice can be certain, it is that no contemporary government, with its unlimited power to create money, will allow a major depression to develop as the result of any failure on its part to increase the quantity of money. No matter how many billions or tens or hundreds of billions of dollars it takes to rescue the mass of debtors and to keep the level of spending on an upward course, the government possesses the means to create those billions. 93
Consistent with this observation, from 1982 to early 1987, in order to prevent the debt crisis from deepening and in order to reduce the unemployment rate, the government embarked upon a reacceleration of inflation. Because the reacceleration came in the midst of a relatively noninflationary or even deflationary psychology, the result was that the new and additional money was held more tightly than it otherwise would have been. The fact that inflation psychology had been greatly diminished encouraged the government to reaccelerate inflation very sharply in 1985 and 1986, in the conviction that it could do so without experiencing the consequences of inflation. As previously mentioned, the money supply was increased in those years by 11.1 percent and 16.9 percent respectively. 94 So long as prices were not rising rapidly and the public was thus not much concerned with inflation, the government felt free to expand the quantity of money at these much more rapid rates.
One of its objectives in rapidly increasing the quantity of money was a major reduction in the foreign exchange value of the dollar, which had continued to increase until well into 1985, as a consequence of diminished inflationary expectations in the United States. This deliberate reduction of the dollar’s foreign exchange value took place in the mistaken belief that it would stimulate exports and at the same time discourage imports, thereby reducing America’s allegedly “unfavorable” balance of trade. A cheaper dollar, it was believed, would make American goods correspondingly cheaper to foreign buyers, who had to buy dollars in order to be able to buy American goods. By the same token, a cheaper dollar was thought to mean that foreign goods and services would be that much more expensive to Americans, who had to buy the foreign currencies in order to buy foreign goods and services, and who now would have to pay that much more for those currencies.
What the supporters of this idea overlooked was that the virtually inevitable consequence of the much higher rates of increase in the money supply in 1985 and 1986 was an acceleration in the rate at which prices rose in 1987 and 1988. This more rapid rise in prices operated to price American exports out of the market, and to encourage imports, thereby confirming what every real economist knew from the very beginning, which was that the government’s policy of inflating in order to reduce the foreign exchange value of the country’s currency was contrary to purpose and an exercise in futility, precisely because it would cause American prices to rise more rapidly.
In 1987, acting no doubt in fear that it was inflating too rapidly, the government adopted a sharply less inflationary policy, which resulted in a relatively modest increase in the money supply of 3.5 percent for that year. 95 This was followed by rates of increase in the money supply of 4.9 percent in 1988, less than 1 percent in 1989, and barely 4 percent in 1990, with most of the increase in 1990 occurring in the last portion of the year. 96
Not surprisingly, after years of having become adjusted to substantially more rapid rates of increase in the quantity of money, the extremely modest rate of increase in the money supply of 1989 and most of 1990 operated to bring about a sharply higher demand for money for holding, a correspondingly lower velocity of circulation of money, and a general inability to repay the great mass
of outstanding debt—i.e., the government drove the economy to the brink of a major depression. Then, as the threat of depression became clear, the government returned to the policy of more rapid increases in the quantity of money, and brought about a rate of increase of almost 9 percent in 1991, more than 14 percent in 1992, and more than 10 percent in 1993. Overall, from the end of 1990 to the end of 1993, the compound annual rate of increase in the money supply was approximately 11 percent. 97
In their response to the depression or near-depression of 1990–1992, the government’s policy makers divided into two camps. A relatively moderate group of inflationists, led by Federal Reserve Chairman Alan Greenspan, and often mistakenly thought of as supporting “tight money,” favored increasing the quantity of money at whatever rate was required to overcome the growing deflation/depression psychology that characterized 1991 and 1992. Once it became clear that that was accomplished and that signs could be found that price increases were starting to accelerate as the result of the rapid infusion of new and additional money into the economic system, this group favored going back to sharply curtailing the increase in the quantity of money. Inasmuch as this group currently controls the actions of the Federal Reserve System, it has been able to have its way, and as of October 1994, the annualized rate of increase in the quantity of money since the beginning of 1994 has been little more than 2 percent. 98 This substantial deceleration in the rate of increase in the money supply has been accompanied by a succession of increases in shortterm interest rates, which the very rapid increase in the quantity of money in the face of widespread deflationary psychology had driven to levels not seen since the early 1950s.
The other group of government policy makers, which includes the president and his advisers, as well as key congressmen and senators in a position to introduce legislation concerning the Federal Reserve System, such as the chairman of the House Banking Committee, favors no substantial deceleration in the rate of money supply increase and, indeed, at least by implication, favors a further acceleration in the rate. Both of these conclusions follow from the fact that the members of this group have become alarmed at each of the increases in shortterm interest rates that has taken place this year and have opposed those increases. They apparently are either unaware or unconcerned that given the rise in sales revenues and profits, and thus in the demand for loanable funds, that the increase in the quantity of money and volume of spending has brought about, the only way that interest-rate increases could have been avoided would have been by virtue of meeting the additional demand for loanable funds with a further and progressively growing increase in the supply of loanable funds provided out of new and additional money. 99 Interest rates have risen because the Federal Reserve has been unwilling to provide the banking system with the additional standard money reserves to make that possible. In contrast, the only point at which the members of this group appear willing to consider the need for slowing down the increase in the quantity of money is when confronted with the existence of rapidly rising prices as an already established fact. Until that time, they believe, inflation is not a problem—it doesn’t even exist.
Both groups of government policy makers confuse inflation with its consequence, rising prices, and are thus prepared to stop it only after it is too late. In this virtual theater of the absurd, the more extreme inflationists criticize the less extreme inflationists for seeing inflation that isn’t there yet and responding to a problem that allegedly either doesn’t exist at all or does not yet exist on a sufficient scale to warrant action of any kind.
When all is said and done, what distinguishes the two groups of today’s government policy makers is only the degree to which they are prepared rapidly to inflate. For today’s “moderate” inflationists, a rate equivalent to 11 percent compounded for three years is enough for a while. For the more radical inflationists nothing is enough, at least until prices are rapidly rising all around them. At that point, they will admit the existence of a problem. The “moderate” inflationists, it should be noted, have recently been losing ground to the more radical inflationists, as the result of appointments to the Federal Reserve Board made by President Clinton.
Whichever group prevails in the year or two ahead, the government’s response to the depression or near-depression of 1990–1992 confirms that recessions and even virtual depressions nowadays do indeed represent inflationary fueling periods. Decades of inflation have so reduced the demand for money for holding and so encouraged indebtedness that all efforts seriously to end inflation serve to bring on a major depression. In the face of that prospect, the government recoils and turns the impending depression into a new inflationary fueling period. The only difference between the conservative inflationists and the radical inflationists on this score is that the conservatives hope to be able to stop the process before it goes too far. They hope to be able to keep the fuel that has already been put out there from being ignited into a major rise in prices, while the more radical inflationists do not hesitate to guarantee such ignition by continuing to pour out the fuel.
Although the conservative inflationists currently control the Federal Reserve System, it should not be expected—assuming that they are able to retain control in the first place—that they will adhere to their program of curtailing the increase in the quantity of money. That
policy, when pursued in 1988, 1989, and 1990, ended up costing President Bush his reelection. It will be substantially harder to pursue the next time, even if, perhaps especially if, a conservative occupies the White House and wants to be reelected. Thus inflation must continue on a substantial scale even under conservative administrations and conservative money-supply managers. This conclusion is further confirmed by the fact that prices rising at a rate of 3 percent a year are now considered “acceptable” and as evidencing the lack of a problem of inflation, even though in a generation such an annual rate of increase must succeed in more than doubling prices and thereby halving the buying power of all incomes and assets that are contractually fixed in dollars.
Only when inflation results in prices rising rapidly enough to evoke widespread public concern and thus to become a major political issue, can the government expect to have substantial public support for a policy of reducing its inflation for any prolonged length of time and at the risk of substantial unemployment. And even then, sufficient public support is by no means guaranteed, as the experience of all the Latin-American countries shows.
Given our present monetary system, the only way the government can continue to keep inflation within the limits set by the Reagan and Bush administrations is if every few years it were willing to provoke a recession at least as severe as the last two. In essence, it would have to return to the boom-bust conditions of the pre–New Deal days, in which limited inflations were always brought to a sharp halt and followed by a depression. Then it could reinstill something of the old mentality of “what goes up must come down” in reference to prices, and of fear of becoming overextended in reference to size of debt and adequacy of cash holdings.
However, there is an essential difference between the conditions of the present and those of the pre–New Deal days. In the days before the New Deal, the existence of a gold standard forced the government to bring inflation to an end. Today, there is no gold standard and thus nothing to force the government to end or even limit inflation. Indeed, the gold standard was abolished precisely in order to make unlimited inflation possible. In the absence of a gold standard, it seems extremely unlikely that today’s voting public will be willing to see unemployment go to 10 or 11 percent every few years in order merely to reduce the rise in prices by a few percent for a limited time.
In view of the nature of the roots of inflation and of the enormous corrupting influence of the power to inflate, it seems likely that in retrospect the 1980s and early 1990s will turn out to have been merely an interlude in the process of accelerating inflation. A real solution to the problem of inflation requires depriving the government of the ability to inflate. 100
Inflation and the Potential Destruction of the
Division of Labor
As I have said, the potentially worst effect of inflation is acceleration to the point of depriving the inflated monetary unit of its acceptability and thus of its character as money. If it accelerates to that point, inflation is capable of destroying a division-of-labor society and with it, the whole of modern material civilization. As explained earlier in this book, the existence of money is an essential precondition of the existence of a division-of-labor society. 101 In destroying the existing monetary unit, inflation is capable of destroying the existence of money as such.
Whether or not the destruction of a given monetary unit is tantamount to the destruction of money itself, depends on the possibility of replacing the monetary unit that has been destroyed, with a new monetary unit. A new monetary unit cannot simply be decreed into existence— it would have no better chance of acceptance than “Monopoly” money or any other play money. In order to enjoy the universal acceptability that is essential to money, the new monetary unit must already have been established as a virtual money. In order for people to be willing to accept the new money, they must have the expectation that they can easily reexchange it with others for all the goods and services that they desire. This means that the new money must already virtually be money. If such an alternative money does not exist, then the only way the destruction of the monetary unit can be followed by the emergence of a new monetary unit is on the basis of a new universally accepted medium of exchange developing out of the conditions of barter. 102 In the interval in which this development takes place, however, which could be very considerable, the economic system would be without money and thus could not sustain the extensive division of labor on which modern material civilization depends.
The collapse of the assignats in 1796, in revolutionary France, was followed by the reappearance of gold and silver coin, which had been the money of France prior to the Revolution and had continued to be the money of the surrounding countries. The reappearance of gold and silver coin also followed the earlier collapse of the American continental currency in our own Revolutionary War, and the subsequent collapse of the Confederate currency in our Civil War. The collapse of the German mark in 1923 was followed by the introduction of a new mark redeemable on demand in American dollars, which, in turn, were redeemable on demand in gold. In these cases, which can be taken as characterizing all modern hyper—
inflations, a new monetary unit could quickly take the place of the unit that had been destroyed, because it either was itself already established as money or was redeemable on demand in an already established money. In the case of the new marks, every German who took them knew that he could use them to buy whatever dollars could buy.
It cannot be stressed too strongly that the ability quickly to replace the monetary unit that has been destroyed has existed in all modern hyperinflations only because these hyperinflations either took place in an environment in which an alternative money already existed in the countries concerned, or occurred only in very limited areas. In the latter case, the existence of money was essentially undisturbed in the rest of the world and in particular in the areas with which the affected countries carried on extensive trade relations.
It is a different story when a hyperinflation takes place over a very extensive territory and the possibility of replacing the monetary unit that has been destroyed, with a new monetary unit, is not present. In that case, the existence of money as such is destroyed, and with it the basis of any extensive division of labor.
History appears to provide at least one major example of this kind: the collapse of the Roman Empire. A prominent history text records:
Debasement of the Roman coinage had begun as early as the reign of Nero. But in the third century, as a result of mounting inflation, widespread hoarding of specie, and sharply reduced revenues, the emperors resorted to reckless adulteration of the imperial coinage to meet their military and administrative costs. As a result, distrust of new currency was widely manifested, by individuals as well as by banks. Ultimately the government refused to accept its own coinage for many taxes and insisted on payment in kind. 103
Gold and silver were prohibited from reemerging as money (which they might easily have done), because of the Roman government’s insistence that they not circulate at a premium over its debased coinage. 104 At the same time, all private hoards of the precious metals were subject to confiscation by the Roman government, which was eager to use them for its own, immediate purposes.
In these ways, the Roman government destroyed the existence of money in its territory, and with it the most extensive division of labor in the history of the world prior to modern times. Among the consequences was the loss of the ability to have a paid, professional army, capable of being supplied with provisions purchased with money. The impregnable legions of Rome’s heyday had to be replaced with a militia of farmers, who lived along the frontier, in virtual economic self-sufficiency, and who were expected to leave their farms and go out and fight when the need arose. 105
Given the absence of a gold and silver money ready to take their place, a simultaneous hyperinflation of all the major paper currencies of the present-day world would have the effect of destroying money as such. Such a hyperinflation must be considered a real possibility, in view of the fact that all the countries of the world pursue deliberate policies of inflation, all of which are subject to the inherent forces of acceleration described above. Furthermore, there is a distinct pressure on each country to inflate more or less in pace with its major trading partners, in order to prevent its currency from sharply appreciating relative to theirs, thereby encouraging a socalled unfavorable balance of trade.
But even if hyperinflation did not occur simultaneously in all the major countries, it could still have the potential for destroying the existence of money in a country whose economy is as large relative to the world’s economy as that of the United States. While Weimar Germany could introduce a new mark based on redeemability in American dollars, it is doubtful that the United States could introduce a new dollar based on redeemability in German marks. The reason is simply the relative size of the two economies. The currency of a vastly larger economy can serve as the foundation for the introduction of a new currency in a country with a much smaller economy. But it is doubtful that the reverse can be true. The United States had the ability economically to rescue a country the size of Germany, including the provision of sufficient dollars to back a new German currency. The provision of dollars to back a new mark neither drew away so many existing dollars from other uses, nor required the creation of so many new and additional dollars, as to create a major problem for the United States. But Germany does not have the means of economically rescuing the United States, nor therefore of providing sufficient marks in real terms for backing a new dollar. The American people could not expect, as could the German people, to be able if necessary to use their new money to obtain a mass of goods from outside the country. The resources to provide the goods would simply not be present. The provision of marks to back a new dollar would require either the drawing away from other uses of so many marks or the creation of so many new and additional marks, as to create a problem of overwhelming dimensions for Germany. The same essential points, of course, are equally applicable to Japan as a potential source of a new dollar.
Thus, hyperinflation in the present-day United States would have the potential for the destruction of money as such in the United States, and with it, the material civilization of the United States. For the modern Western World in general and for the United States in particular, inflation has destructive potential on a scale not seen since the onset of the Dark Ages.
GOLD VERSUS INFLATION 951
PART C
GOLD
1. Freedom for Gold as the Guarantee Against the Destruction of Money
The solution for every aspect of the inflation problem lies in gold (and silver). The widespread ownership of gold and silver coins by American citizens, and the concomitant willingness of large numbers of Americans to accept them in payment for their goods and services, would be a guarantee against the destruction of money through hyperinflation. It would mean that a new money would be ready to take the place of the present paper money, should the latter ever be inflated into extinction.
However remote the possibility of hyperinflation and the destruction of money in the United States may appear at the moment, it should be kept in mind that the time required for such a possibility to loom as large as it did in 1979 and 1980 is no greater than the time that was required to make it recede. In other words, in the space of just a very few years conditions are capable of undergoing large and unexpected change, with the result that what may seem so unlikely at the present moment as scarcely to be worth consideration, can be upon us relatively quickly and unexpectedly. Given the nature of the present monetary system, all of the basic elements are in place that are required to make hyperinflation possible and thus to make the destruction of money possible. Because of the utter devastation that would then ensue, it is very definitely worth taking precautions against any such possibility, which, of course, is what extensive ownership of gold and silver coins would provide.
As I explained in Chapter 12, in a period of rapid inflation the market itself tends to remonetize gold and silver through their growing use as “inflation hedges.” The imperishability, homogeneity, and divisibility of gold and silver, coupled with their existing high value in a small bulk, based on their utility and rarity as ordinary commodities, make them ideally suited for use as inflation hedges by most people. Their minimal costs of storage and transportation relative to their value, means that in a period of rising prices one can retain almost all of one’s purchasing power simply by owning gold or silver. All that is necessary is that their price rise merely to the same extent as the average of prices. Although, if this happens, one will suffer the modest loss of having to pay storage costs, this is far less of a loss than tends to be suffered in connection with the customary forms of saving and investment in such conditions.
The customary forms of investment lose because of all of the ways in which inflation undermines capital formation. The customary forms of investment can be compared to the purchase of equipment which inflation will cause to end up as mere heaps of scrap iron. At some point, of course, as the result of inflation, even the price of scrap iron in the future will be higher than the price of the equipment today. But when it is, the prices of everything else will obviously have increased by much more. Thus the purchaser of ordinary business assets, or any form of claim to such assets, ends up, on average, a major loser. He starts with the price of equipment, and ends with the price of scrap iron, while the prices of the things he wants to buy advance more or less in line with the price of replacement equipment. The example may be somewhat exaggerated, but it is correct in describing the nature of what happens. For such is the result of the taxation of funds required for replacement, of the prosperity delusion, of widespread malinvestment, of the loss of safety of all the traditional, conservative forms of investment, and of the withdrawal-of-wealth effect.
Since the ownership of gold and silver entail a much lesser loss, their ownership becomes relatively favored, and thus, for a considerable time, their price can actually rise by more than the average of prices, as larger and larger numbers of people shift portions of their savings into them. In effect, because of their special suitability for serving as inflation hedges, the phenomenon of substantial inflation creates a new and additional demand for them, on the basis of which their value is substantially increased. (By the same token, of course, the moment inflation comes to be perceived as less of a threat, the demand for gold and silver as inflation hedges diminishes, and thus their price declines relative to the average of prices.)
It follows that if not prevented from doing so by government interference, the market itself would take all of the necessary precautions against the destruction of money, by preparing the ground for the reemergence of gold and silver as money. For the remonetization of the precious metals would readily follow from their being owned and sought as a store of value by a substantial portion of the population. 106
A Proper Gold Policy for the Government
The process of the spontaneous remonetization of gold and silver would be enormously accelerated in the absence of various government restrictions. It goes without saying that buyers and sellers of gold and silver should not be subjected to any invasion of their privacy, such as having to report their purchases and sales to the government. The purchase and sale of gold and silver should also not be subject to taxation of any kind. The ability of people to protect themselves by means of the
ownership of gold and silver from the loss of purchasing power that inflation causes should not in any way be reduced by taxes that must be paid merely because the price of gold or silver rises. In the absence of such taxes and with the ability freely to buy and sell, the ownership of gold and silver would increase much more rapidly.
In addition, the government should do absolutely nothing to prevent the importation of gold from abroad. The present quantity of gold that is owned by American citizens and by their government is almost certainly substantially below the quantity that they would want to own under a gold monetary system. The present real value of an ounce of gold is likewise far below what it would be under such a system. The ability freely to import gold now means the ability to acquire it while it is still relatively cheap.
An integral part of the process of spontaneous remonetization would be the enforcement of contracts calling for payment in gold or silver, along with the freedom of such contracts from taxation on the mere rise in price of gold or silver. Thus, for example, the law should enforce such contracts as the loan of 100 ounces of gold today in exchange for the repayment of 105 ounces of gold a year from now. At the same time, it should regard as the taxable income in connection with such a contract merely the 5 ounces of gold interest, not any increase in the paper money price of the 105 ounces of gold principal and interest.
If such a policy existed, any substantial perception of inflation as a serious problem would be accompanied by the emergence of contracts payable in gold or silver. Gold and silver capital and credit markets would develop. At the same time that people became unwilling any longer to lend paper money on a longterm basis, because they came to recognize that they must lose by doing so, they would become eager to lend gold. Provided the repayment of the principal could be assured, the receipt of any gold interest whatever would represent an improvement over the mere holding of the gold. Thus, for example, a recurrence of the conditions of the late 1970s and early 1980s, in which longterm fixed-rate mortgages were about to disappear, would mean the disappearance of such mortgages only in terms of paper money. Longterm fixed-rate mortgages payable in paper money would be replaced with longterm fixed-rate mortgages payable in gold.
The spread of contracts payable in gold or silver would powerfully promote the remonetization of these metals, because whoever came to owe gold or silver would be a willing seller for gold or silver. The existence of a growing number of sellers seeking gold or silver as a means of meeting their contractual obligations would widen the exchangeability of gold and silver beyond what it would be on the basis of the demand merely for holdings of gold and silver. The exchangeability of gold and silver for all kinds of ordinary goods and services would soon become great enough to make everyone willing to accept them, because all would have the confident expectation of finding others willing to take them in turn. At that point, gold and silver would once again be money.
An essential aspect of gold and silver achieving a monetary role is the abolition of all restrictions on the ability of merchants to practice discrimination between units of precious-metal money and units of paper money bearing the same face value. This means, for example, that merchants should have full freedom to discriminate between an old $20 gold piece (or a contemporary restrike of such a gold piece) and a $20 bill. They should be able to accept the $20 gold piece as the equivalent of however many hundreds or thousands of dollars of paper money as its market value dictates. In exactly the same way, they should be free to discriminate between pre-1965 silver coins and contemporary coins and currency of the same face value. They should be free to accept a roll of pre-1965 silver quarters with a face value of $10 as the equivalent of however many present-day $10 bills as its market value dictates. By the same token, they should have the freedom to take gold and silver coins of a given face value as their standard of the meaning of the number of dollars of that face value, and to declare paper money of the same face value to be acceptable only at a discount, that is, as worth only so many cents on the dollar of precious-metal money. For example, if a $20 gold piece has a market value of $500, merchants should be able declare that the $20 gold piece is what they mean by $20 and that they accept paper dollars at the rate of only 4 gold cents on the dollar.
The existence of gold and silver moneys operating alongside of a fiat paper money, and in free competition with the fiat money, would greatly accelerate the doom of the fiat money, unless the latter were made redeemable on demand in gold or silver at a fixed, known rate, which there was no expectation that the government would change. This is because in these circumstances, people would have an alternative to the depreciating fiat money. In the face of this alternative, the demand for paper money would quickly evaporate as people shifted their allegiance to the vastly superior gold and silver moneys, which retained or increased their buying power as the fiat money declined in buying power. They would want their principal and interest, their pensions, life insurance, rental agreements, and all other contracts payable in the gold and silver moneys they could trust, and not in the depreciating fiat money. To remain in existence at all, the fiat money would have to be made into a gold-standard
GOLD VERSUS INFLATION 953 money—which is what it means to be redeemable on demand at a fixed, unchanging rate. These results would follow from people’s direct perception, in their day-today transactions, of the superiority of the precious metals in retaining their buying power. They would see, for example, how a $20 gold piece came to be equivalent to hundreds or thousands of dollars of paper money, and how a silver dime or quarter came to be equivalent to larger and larger multiples of fiat money. In other words, they would directly perceive the fact that the problem of inflation lay in the paper money, which they would then turn away from. 107
It follows from the above description of things that gold is the money of a free market and that fiat money can be maintained in existence only by the forcible suppression of the competition of gold. It should also be clear that the requirement that paper money be redeemable in gold at a fixed, known rate is not any form of price control, as some economists with inadequate knowledge of the subject maintain, but an indispensable means of keeping paper money in existence when it must compete in a free market. In a free market, there would simply be no demand for an irredeemable paper money, which in the nature of things is capable of being inflated without limit.
The government, which has done almost everything in its power to destroy the use of gold as money, could take a number of important and perfectly legitimate measures to promote the remonetization of gold. 108 For a nominal fee, and for a limited number of years, it could allow private minters, who would manufacture new gold or silver coins, to use the seal of the United States on one side of their coins, until such time as the market became familiar with their respective trademarks. It could and should also begin to collect some tax revenues in gold and silver, such as the proceeds of the tariff, and perhaps some excise taxes. This measure would immediately sharply increase the demand for gold and its value. It would immediately make payment in gold acceptable to whoever had to pay such taxes. It would be a clear indication to everyone of the course of things to come. It would also provide the government with a secure source of revenue that would be more than sufficient to maintain its essential, non-welfare-state, peacetime functions. Thus, the continued existence of the government itself would be substantially secured against the possibility of a currency collapse.
The collection of these taxes in gold would promote the highly desirable objective of the monetary demand for gold increasing as far as possible in advance of major financial obligations coming to be expressed in gold. This is necessary in order for borrowers of gold not to find that it is vastly more difficult to acquire it at the time of repayment than at the time they borrowed it. A gradually increasing volume of contracts payable in gold would present no major problem, because the upward pressure on the real value of gold created by a growing demand for it to make principal and interest payments, and to buy from those seeking gold for such purposes, would at the same time elevate its value for all the new contracts being written. However, a measure such as the collection of the tariff and various excise taxes in gold, which could be phased in over a period of two or three years, would help to increase the monetary demand for gold all the more quickly, and thus correspondingly diminish any possible burden imposed by a growing monetary demand concentrated more heavily in the future. It would make gold a safe medium that much sooner in which to contract a large volume of financial obligations.
The same objective would be promoted by the government’s adopting a policy of auctioning off, for gold, various assets it presently owns and should not own. These include its vast landholdings in the Western states and Alaska, the postal system, Amtrak, Conrail, the Tennessee Valley Authority and other facilities for producing electric power, and the interstate highway system. The gold taken in from the sale of such assets might be used to increase the gold stock available for the future redemption of the paper currency and outstanding fiduciary media, or, if it should prove excessive for that purpose, for the redemption of a portion of the national debt.
A further perfectly legitimate measure that the government might adopt in connection with promoting the remonetization of gold would be the enactment of a creditors’ protection bill, which would make some modest portion of existing contracts, such as 5 percent of the sums involved, payable in gold, at the price of gold prevailing at the time of the bill’s enactment. Such payment would be at the option of the creditor, who would elect it only in the event that the paper money due him fell below the price of the gold in question. As well as encouraging the use of gold, this measure would ensure that inflation would not be able to wipe out the wealth of creditors entirely. Depending on the extent to which the price of gold later came to rise relative to the average of prices, the measure could succeed in preserving a significant portion of the purchasing power of the contractual sums to which it applied, irrespective of the degree of inflation. For example, an outstanding contract calling for the payment of $1 million would be construed as requiring the payment of a quantity of gold presently equal to $50,000. If the prevailing price of gold were $500 per ounce, this would mean that such a contract required the payment of 100 ounces of gold at the option of the creditor. This would guarantee that no matter how
great inflation became, the creditor would receive at least some significant payment in real terms. Indeed, the worse inflation became, the more would the rise in the price of gold tend to outstrip the rise in the average of prices. Thus, if, as is easily conceivable, in the course of a major inflation the price of gold rose seven or eight times as much as the average of prices, the creditor would end up at least receiving 35 or 40 percent of the real payment due him.
Neither the government nor anyone else would have to take payment in gold or silver in actual coin or bullion. Payment could be made with gold-denominated banknotes or checks. But the government could legitimately require, and indeed should in fact require, at least for the length of the period of transition and for some time beyond, that all banknotes and checks payable in gold or silver, be covered by a 100-percent-gold-or-silver reserve, as the case may be. The government itself should never accept anything but either coin or bullion or notes or deposits 100 percent backed by coin or bullion. If it accepts any form of fractional-reserve money, it places itself in a position in which it implicitly grants credit, which is not part of its proper function and which it has no right to do. The implicit granting of credit is entailed to the extent that the claim one accepts or holds is backed by debt rather than by actual money. Until one receives actual money or a fully backed receipt for actual money, one has not yet been paid, but is granting credit.
2. The Case For a 100-Percent-Reserve Gold Standard
The establishment of a monetary system that was based not only on the widespread use of gold and silver coin, but also on the principal of a 100-percent-gold-or-silver reserve against banknotes and checking deposits, would mean security not only against a possible currency collapse but against every aspect of inflation. It would be a monetary system that would be both inflation proof and deflation/depression proof.
Under a 100-percent-reserve gold standard, every unit of money is a physical unit of gold. The paper currency and checking deposits are merely money substitutes, i.e., transferable claims to actual money, which is gold. For example, if the dollar were defined as one-twentieth of an ounce of pure gold (which it was, roughly speaking, for most of our history), then there could be only twenty times as many dollars in the United States as there were physical ounces of gold. If, say, there were $20 billion of paper currency and checking deposits outstanding, there would have to be one billion ounces of gold standing behind them.
This example, of course, is purely for purposes of illustration. I certainly do not advocate the definition of the dollar as one-twentieth of an ounce of gold today. Given all the inflation in the United States in this century, one three-thousandth of an ounce would be a far more reasonable definition, and, as time goes on and still more inflation ensues, the amount of gold in terms of which the dollar was defined would have to be still less. 109 In fact, after a period of conversion, I would advocate abandoning the very name “dollar” and defining the monetary unit simply as a weight of gold, such as the gold ounce or the gold gram. We would then speak of “ounces” or “grams” of gold as the British, French, and Italians once did of pounds, livre, and lire of silver. (All of these units originally denoted a troy pound of silver.) 110
A 100-percent-reserve gold standard would obviously provide a guarantee against inflation. Gold is rare in nature and extremely costly to mine in anything but relatively small amounts. A gold money would increase in quantity from year to year probably by only about two or three percent, if that. Between a modest growth in population and thus in the supply of labor, and a rise in the output per worker based on technological progress and capital accumulation, it is likely that in most years the increase in the overall supply of goods would outstrip the increase in the supply of gold. The result would be that prices would show a tendency to fall from year to year. As I previously pointed out, this is actually what happened in the nineteenth century, in the generation preceding the discovery of the California gold fields, and again, in the generation from 1873 to 1896.
Falling Prices Under the 100-Percent-Reserve Gold
Standard Would Not Be Deflationary
Paradoxically, it is precisely the gold standard’s success in preventing inflationary increases in the money supply that is the source of much of the opposition to it. People believe that the fall in prices that would occur under the gold standard would represent deflation. And, as a result, they believe that the economic system would languish in a state of more or less permanent depression.
Amazingly, even most of the supporters of the gold standard appear to believe this in some form. They advocate a fractional-reserve gold standard in the belief that it is necessary to make the money supply grow more rapidly than the increase in gold taken by itself. In effect, they want each additional ounce of gold to make possible the creation of money substitutes representing claims to two, five, ten, or more ounces of gold. They apparently do not realize that if they were right, the implication of their position would ultimately be no gold standard at all. For if it in fact were necessary for the quantity of money to grow more rapidly than the supply of gold, then each year the supply of gold would represent an ever smaller fraction of the supply of money. Eventually the fraction
would approach zero. If, on the other hand, gold is always to constitute the same fraction of the money supply, then it is impossible for the money supply to grow more rapidly than gold, and one may as well have a 100-percent-gold reserve. Indeed, the rate of increase in the supply of gold itself is likely to be greater under a 100-percent-reserve system than under any fractional-reserve system in which the fraction of gold is fixed. This is because the real value of gold is greatest under a 100-percent-reserve system and therefore the inducement to the increase in its supply the strongest.
Of course, it should be obvious on the basis of previous discussion, that the fall in prices that would occur under the 100-percent-reserve gold standard would not at all represent deflation. 111 In the nature of the case, such a fall in prices would be the result of an increase in production, not a decrease in spending. Because of this, it would not be accompanied by any of the essential symptoms of deflation: namely, a greater difficulty of repaying debts and a wiping out of the rate of profit on capital invested.
Under the 100-percent-reserve gold standard, total sales revenues in the economic system would in fact modestly increase from year to year, in accordance with the modest increase in the gold money supply and the volume of spending in terms of gold. The average business firm would thus find that its sales revenues modestly increased from year to year. The fact that the average business firm might have to sell at somewhat lower prices from year to year would not in any way imply a reduction in its sales revenues. On the contrary, it would have a supply of goods to sell that was larger by more than corresponded to the fall in prices, and was so to a significant degree. The fall in prices, it cannot be stressed too strongly, would be the result not of a fall in spending, not even of an increase in supply in the face of a given volume of spending, but of an increase in supply which outstripped an increase in spending. In such circumstances, a greater increase in the supply of goods than corresponds to the fall in prices exists to precisely the same extent as the increase in the volume of spending in terms of gold.
The context of why prices fall under the 100-percent-reserve gold standard must be kept in mind: it is because while spending rises 2 or 3 percent a year, in accordance with the increase in the gold supply, production rises 4, 5, or 6 percent a year. This kind of drop in prices is not accompanied by declining sales revenues, but by modestly rising sales revenues. The rise in sales revenues is the corollary of the rise in spending. Any business firm that increases its production in accordance with the economy-wide average increase has no greater difficulty in earning a dollar of sales revenue at the lower prices that prevail later on than it had at the higher prices that prevailed earlier. In fact, it necessarily has a somewhat easier time earning a dollar of sales revenues, for the supply of goods it is able to produce and sell goes up by more than the price of its goods must fall. Because it is no harder to earn a dollar later on than it was earlier, but easier, there is not only no greater difficulty of repaying debts, as there is under deflation, but a lesser difficulty. Thus, this symptom of deflation is most decidedly not present.
Nor is the fall in prices under the 100-percent-reserve gold standard accompanied by any wiping out of the average rate of profit in the economic system, which is the other leading symptom of deflation. On the contrary, the increase in the quantity of money and volume of spending that takes place under the 100-percent-reserve gold standard represents a corresponding addition to the nominal rate of profit. To whatever extent the increase in production and supply outstrips the increase in the quantity of money and volume of spending, the resulting fall in prices is merely the measure by which the addition to the real rate of profit exceeds the addition to the nominal rate of profit. 112
Thus, falling prices under a 100-percent-reserve gold standard simply do not represent deflation. They do not make it more difficult for the average debtor to repay his debts and they do not reduce the average rate of profit.
It is a very different story, however, when prices fall not as they do under the 100-percent-reserve gold standard, because of more production, but because of less spending in the economy. Then the fall in prices is accompanied by a decline in the sales revenues of the average seller. Then it is more difficult for the average debtor to repay his debts, because whether he has more goods to sell or less goods to sell, there simply isn’t as much money to be taken in by him. And because sales revenues fall, the average rate of profit falls, corresponding to the lag between a fall in productive expenditure and a fall in depreciation cost and cost of goods sold. 113
The fact is that deflation is not a matter of falling prices, but of a contraction in the volume of spending in the economy. This is what produces the essential symptoms of deflation: the general inability to repay debts and the wiping out of business profitability. If this point is kept in mind, then it becomes clear that a 100-percent-reserve gold standard not only would not cause deflation, but would actually be the best possible protection against deflation.
The 100-Percent-Reserve Gold Standard as the
Guarantee Against Deflation
There are two basic reasons why the 100-percent-reserve gold standard would be a guarantee against defla—
tion. First, under a 100-percent-reserve gold standard, nothing could happen that would suddenly reduce the quantity of money in the economic system. Once gold money comes into existence, it stays in existence. It is not wiped out by the failure of debtors, as are fiduciary media. Second, nothing could happen that would suddenly increase the need or desire of people to hold money rather than spend it, because none of the artificial inducements to a lower demand for money for holding would exist that set the stage for such an increase. It must be recalled that what creates the potential for a sudden increase in the need and desire to hold money is that first, people are misled into experiencing an artificial decrease in their need and desire to hold money. All the inducements that mislead them into this decrease are caused by the prior undue increase in the quantity of money, especially in the form of credit expansion. 114 A 100-percent-reserve gold standard would thus be a system in which the quantity of money would not decrease and the demand for money for holding would not suddenly increase. As a result, it would be a system in which total spending in the economy would virtually never contract. Thus, as stated, it would be a system that was deflation proof as well as inflation proof.
Under the 100-percent-reserve gold standard, the desire to hold money would be substantially greater than it is today and also greater than it would be under a fractional-reserve gold standard. Money would be something for which people would have great respect and would want to own in abundance. And they would succeed in owning it in abundance. However paradoxical it may seem, the 100-percent-reserve gold standard would be a system of enormous financial liquidity. It would be a system in which the quantity of money measured in terms of its absolute buying power and relative to such things as current liabilities, would be far greater than under any other system. It is precisely for this reason that there would be no basis for any sudden increase in the need or desire of people to own money. They would already own all the money they needed to.
This point may be difficult to grasp. The prevailing view is that anyone who wants to hold money is practically a public enemy, and that financial virtue, at least from a social point of view, consists of everyone spending his every dollar as rapidly as possible.
However, a different conclusion emerges if one considers a 100-percent-reserve gold standard and thinks through the effects of people wanting to hold money more tightly. Thus, let us imagine that there are only a billion ounces of gold in the world and that initially people are spending this gold fast enough to generate a five billion gold-ounce world “gross product”—in other words, the socalled velocity of circulation of money, or turnover, is five. Now people decide they want to hold the gold much more tightly. The velocity of circulation and the world “gross product” plunge from five and five billion respectively to, say, two and two billion respectively.
At a sufficiently lower level of wages and prices, the two billion ounce world “gross product” can buy all that the five billion ounce world “gross product” bought. The only difference is that the buying power of the one billion ounce money supply will be much larger and that the money supply will stand in a much higher ratio to magnitudes such as total current liabilities and total accounts receivable. These magnitudes will fall in accordance with the fall in spending, and then stay down as wage rates and prices fall to make possible a recovery in employment and production. In other words, the result will be that the system will have more money in terms of actual buying power and will thus be correspondingly more liquid. 115
Under a 100-percent-reserve gold standard, a sufficiently high degree of liquidity would once and for all long ago have been achieved and no further need would exist suddenly to increase it. The system would operate permanently in accordance with the most conservative rules of financial management and never be placed in the position of having to experience a financial contraction. As a result, the kind of example just given would not actually occur under the 100-percent-reserve gold standard. It is descriptive, however, of what happens when the artificial stimulus given to spending by inflation comes to an end.
On the basis of all these reasons, it should be clear why the 100-percent-reserve gold standard would be the solution to the boom-bust business cycle, as well as the solution to the problem of inflation.
Further Virtues of the 100-Percent-Reserve
Gold Standard
Among the other major virtues of the 100-percent-reserve gold standard is that, in common with the more serious forms of a fractional-reserve gold standard, it would make possible a unified world monetary system with all its attendant advantages to international investment and the international division of labor. International investment need no longer be subject to the risk of depreciation in the foreign currency in which the investment was made. If the foreign currency is also a weight of gold, then for all practical purposes it is the same as the domestic currency.
Even more important, and with firmer guarantees than any form of fractional-reserve gold standard can provide (because of the total ban it establishes on the creation of new and additional money by the government and the
banking system), the 100-percent-reserve gold standard would compel governments to operate with balanced budgets, since they would have to turn to their citizens for all the money they spent. Governments would simply no longer have the power to spend more than the taxes they collected. They could absolutely no longer finance their deficits by creating money. Nor could they hope to finance them for very long by borrowing gold, since a policy of borrowing gold would plunge a government into bankruptcy and would soon have to be abandoned, or, more likely, avoided in the first place. The consequent absolute physical need to balance the budget would in turn, of course, greatly reduce the popularity of all government spending programs, because all of them would be perceived in inseparable connection with the taxes that would be required to pay for them. This in turn would mean fewer and smaller such programs; hence, a smaller, less expensive, and less destructive government. The same principle would apply to wars, as well. Instead of being perceived as periods of prosperity, the higher taxes required to pay for them would make the public correctly identify them as periods of impoverishment. As a result wars would be less frequent and of shorter duration.
In addition, a 100-percent-reserve gold standard would provide an environment enormously conducive to saving, investment, and capital accumulation. The arbitrary redistribution of wealth and income caused by inflation would end; the future purchasing power of money would be assured; the general profitability of investment would be assured (something which fractional-reserve gold standards with their attendant depressions cannot do); and neither profits nor interest would be artificially inflated, as occurs today, and then taxed and consumed as though they were genuine gains rather than being necessary merely for the replacement of assets at higher prices. On the contrary, under the 100-percent-reserve gold standard, far more than under any form of fractional-reserve gold standard (because of the more limited potential for increase in the quantity of money), a substantial portion of profit and interest income in real terms would automatically escape all taxation—namely, all that portion which took the form of a greater buying power of the original capital funds resulting from lower replacement prices of assets. Furthermore, unlike under the fractional-reserve gold standard and its accompanying credit expansions, there would be no malinvestment or withdrawal-of-wealth effects to hamper capital formation.
The Moral Virtue of the 100-Percent-Reserve
Gold Standard
What underlies the practical advantages of the 100-percent-reserve gold standard over any form of fractional-reserve system is its moral superiority. It operates consistently with the law of the excluded middle and does not attempt to cheat reality by getting away with a contradiction. It recognizes that lending money precludes retaining that money in one’s possession, and that retaining money in one’s possession precludes lending it. The 100-percent-reserve system follows the principle that either one lends money or one retains the money, but not both together, with one and the same sum of money. In contrast, a fractional-reserve system applied to checking deposits or banknotes is a deliberate attempt to cheat reality. It is the attempt to have one’s money and lend it too. It is a system fully as dishonest as all other recurring efforts that take place in one form or another in attempts “to have one’s cake and eat it too.”
Just as such attempts typically entail taking away someone else’s cake, fractional-reserve banking applied to checking deposits or banknotes entails some parties gaining credit at the expense of other parties, and others unexpectedly being placed in need of credit. Again and again it results in financial contractions, depressions, and deflation, accompanied by widespread bank failures, which last represents the cheating coming home to roost. Again and again, individuals who believed they owned money, who would never have dreamed of lending out the money they needed to hold to make purchases and pay bills, and thus of lending to the point of their own insolvency, wake up to learn that the checking deposits or banknotes they hold represent loans that have become uncollectable.
Imposition of the 100-percent-reserve principle in connection with checking deposits and banknotes is the imposition of financial honesty. It would require nothing more than that banks ask their customers whether in making a deposit or buying banknotes their intention was to lend money to the bank or to keep their money at the bank. In the first case, the bank’s customers would receive a credit to a savings account or certificates of deposit, neither of which they could spend until such time as they withdrew the funds they had lent, which would entail equivalently reducing their savings account or redeeming their certificates of deposit. During the interval the bank, for its part, could lend the customers’ money out, as it thought best. In the second case, the customers would receive either a credit to their checking account or banknotes, both of which they could spend as they wished. But so long as the customers held their funds in the form of checking accounts or banknotes, the bank could not lend or spend the proceeds its customers had entrusted to it. That money would be the customers’ money, which they were not lending to the bank but merely keeping at the bank.
It follows from this discussion that it is mistaken to
believe that the imposition by law of 100-percent-reserve banking in connection with checking deposits and banknotes would constitute government interference. It would constitute nothing more than the just exercise of the government’s power to combat fraud—the fraud of having one’s funds lent out despite the bank’s deliberate creation of the impression that in making a checking deposit or purchasing banknotes one fully retained the possession of one’s funds.
Shysterism in any form is always slippery. Thus if it occurs to anyone to argue that the banks’ customers are not victims of fraud because they clearly know and understand that their funds are being lent out, then the answer is that in that case they would be parties to fraud. Their fraud would be the attempt to make payment to others not with money or reliable warehouse receipts for money, but with claims to debt. They would be engaged in the willful contradiction and deception of claiming to pay someone when in fact imposing on him the position of being a grantor of credit.
It should be understood that everything I have said in connection with the subject of the fraud entailed in fractional-reserve banking applies to a context in which the establishment of a 100-percent-reserve gold standard would be a real possibility. It is pointless to accuse either banks or their customers of any kind of fraud in connection with fractional-reserve banking in a context such as that of the present, in which the overwhelmingly greater fraud exists of the government’s creation of a monetary standard that is utterly nonobjective and arbitrary, namely, the fiat-paper standard.
Supporters of fiduciary media and credit expansion like to argue that their effect is an increase in the volume of capital and credit that exists in the economic system. This is true, of course, only in terms of a monetary unit that is of lesser value because of credit expansion and the creation of fiduciary media. I have already shown at length how credit expansion and fiduciary media undermine capital accumulation in real terms. It is worth pointing out, however, that even if the advocates of credit expansion and the creation of fiduciary media were correct, any loss of capital and credit as might be attributable to their elimination could far more than be made up for by reduction in the national debt. As of the end of 1993, the cumulative total of loans and investments acquired by the banking system in connection with the creation of fiduciary media was approximately $738 billion. 116 At the same time, the national debt, which is the measure of the cumulative siphoning off of savings and capital into the consumption of the government, stood at almost $4.6 trillion, i.e., was more than six times as large. 117 Thus, even if fractional-reserve banking and the issuance of fiduciary media, instead of undermining capital formation as they actually do, somehow made a contribution to capital and credit that could be measured as equal to the amount of debt held by the banking system as the result of the issuance of fiduciary media, the loss of such contribution could easily be far more than made good by the reduction of the national debt.
It is simply absurd for anyone to engage in sophistic speculations about how to use methods of cheating as sources of additional capital, when overwhelmingly more capital could be made available by the perfectly honest method of reducing the national debt and ultimately eliminating it. Unfortunately, there are people who like to speculate in this way because of the perverse attraction cheating holds for them.
The Monetary Role of Silver
The existence of a 100-percent-reserve gold standard would imply a major monetary role for silver. This is because the extremely high real value that would then exist for even the smallest practical-sized gold coin would make it impossible for gold coins to effectuate most retail purchases. Even at the relatively low prices of gold that have prevailed in the last decade, the smallest practical-sized gold coin has a buying power that is too high for many retail transactions. For example, at a price of gold of $400 per ounce, the smallest practical-sized gold coin has a buying power of approximately $20. (This is a coin weighing slightly less than a twentieth of an ounce of gold, which was the size of the smallest old U.S. gold coin, namely, the one-dollar gold piece.) Under a full, 100-percent-reserve gold monetary system, the buying power of an ounce of gold would be far greater, which would rule out the use of gold coin in the great majority of retail transactions.
The fact that the value of gold would be too great for most retail transactions implies that if the monetary system is to make extensive use of precious-metal coins, a major monetary role must exist for silver, which would be in use alongside gold, constituting a second, independent, parallel standard. 118 Silver was the market’s answer historically to the problems posed by the very high real value of even the smallest gold coins. For many centuries it had a value of approximately one-fifteenth that of gold.
The widespread use of silver coins, rather than gold-backed banknotes or checks for most day-to-day retail transactions, is implied by the fact that under a 100-percent-reserve system, there is a substantial cost in using banknotes and checks. This is because the banks must charge fees high enough to cover the cost of maintaining and safeguarding the reserves, as well as doing whatever else is necessary in providing the services of banknotes and checking deposits. Thus the use of coins is made
preferable in most such cases, but gold coins are too valuable for most day-to-day retail transactions, which leaves silver coins.
Under a 100-percent-reserve gold standard, the monetary role of silver might be so great that silver coin and bullion would constitute as much as a third of the overall supply of money. This estimate is consistent with the fact that today, paper currency in denominations of $100 and less, together with subsidiary coin, constitutes on the order of a third of the overall quantity of money, while checking balances constitute the rest. Under a 100-percent-reserve gold standard, silver coins would take the place of most of today’s paper currency and would have a buying power ranging from today’s $10 bills up through today’s $100 bills.
This estimate of the buying power of silver coins is consistent with the assumption of an ounce of gold having a buying power of approximately $3,000 of today’s money, and an ounce of silver coming once again to have a buying power of one-fifteenth as much, that is, of approximately $200. The assumption of a buying power of $3,000 for an ounce of gold follows from dividing the present government-held gold stock of approximately 260 million ounces into two-thirds of $1,150 billion, which is the approximate present money supply of the United States. It is divided into two-thirds of the money supply on the assumption that silver would constitute the other one-third of the money supply. On these assumptions, a silver coin the size of the pre–1965 dime, which contained about .07 ounces of silver, would have a buying power of about $14, while the larger silver coins had proportionately greater buying power. (Recognition that the precious metals could attain such buying power helps to explain the very low prices that prevailed in previous centuries. For example, the fact that in the mid–nineteenth century one could buy a steak in a restaurant for 10¢ or a pot of coffee for 2¢, is consistent with such high real values of the precious metals.)
With such great buying power on the part of the precious metals, even the smallest practical-sized silver coin would have too great a purchasing power for small retail transactions, namely, those of approximately $10 or less in terms of today’s money. Historically, this is what necessitated the existence of a subsidiary token coinage ranging from 5 cent pieces on down to half-cent pieces. A lowly half-cent piece had a buying power comparable to 70 cents of today’s money.
The case of subsidiary, token coinage represents the one proper area for the issuance of fiduciary media. On the one hand, the existence of such coinage is necessary to facilitate transactions that could not otherwise readily be facilitated. As such, it does not displace gold or silver but supplements them. On the other hand, there is no convenient way to make the issuance of such coinage profitable except by the earning of interest on the lending out of a substantial portion of any standard money received by the issuer in exchange for the token coins. To require a 100 percent reserve in this case would be to require that the token coins circulate at a premium over the gold or silver for which they were redeemable, a premium equal to the cost of providing them and of maintaining the gold or silver reserves. If the same token coins were to remain in circulation for many years, their redemption value in gold or silver would have to be progressively reduced in order to cover the ongoing cost of maintaining the gold or silver reserves. Such difficulties are eliminated by providing for the costs out of interest earnings on the lending out of much of the standard money the issuer receives in exchange for the token money.
Because such coinage supplements the precious metals rather than displaces them, its issuance does not diminish their value, as does the issuance of fiduciary media in normal circumstances. On the contrary, to whatever extent the precious metals serve as a reserve against the token coinage, their value is somewhat enhanced, because now, indirectly, in the form of a reserve, they enter to an important extent into the token coinage, which they could not do directly, as circulating coin. Moreover, unlike the case of fiduciary media in normal circumstances, there is no danger of credit expansion from any excess issuance of token coinage. Whoever would seek to expand credit by manufacturing and lending out additional rolls of pennies and nickels would find that virtually all of them immediately came back to him in exchange for gold or silver, because there would be no way to induce people suddenly to increase the proportion of their money that they wished to hold in the form of minor coins. If the issuer proved unable to redeem his coins in such a case, it is unlikely that anyone’s loss would be very significant if he had behaved reasonably and had accepted no more than modest amounts of such additional coins. The largest losers would probably be the customers who had borrowed the coins and who had not been able to pass all of them before they lost their redeemability.
3. The 100-Percent-Reserve Gold Standard as the Means of Ending Inflation Without a Depression
The remonetization of gold and silver on a 100-percent-reserve basis holds out the prospect of ending inflation once and for all and of doing so without causing a financial contraction or depression. 119 In order to explain how, it is necessary to begin with the following facts.
As of December 1993, the money supply of the United States was approximately $1,100 billion, and the socalled gross domestic product (GDP) of the United States was running at an annual rate of about $6,400 billion. 120 With an $1,100 billion money supply and a $6,400 billion GDP, the implied income velocity of money was somewhat less than 6.
If all that were done at this point was to stop all further inflation of fiat money, make it redeemable in gold, and permanently limit the rate of increase in the quantity of money to the rate of increase in the supply of gold, the sharply higher demand for money that would result might well drive velocity down to 4 or even 3 (its approximate level through most of the 1930s) and thus initially reduce nominal GDP to close to $4,000 billion or even $3,000 billion. In the process, of course, there would be an enormous wave of bankruptcies and bank failures, which would have the potential for wiping out the greater part of the money supply and thus reducing nominal GDP and total spending all that much further. Indeed, starting with the present velocity of almost 6, it may well be the case that the deflationary potential which exists today is substantially greater than the deflation that occurred between the years 1929 and 1933, which started in the face of a velocity of circulation in the neighborhood of 4.
All this, of course, indicates the enormous difficulties in the way of ending inflation under present monetary conditions. But not to end inflation means the continuation of all of its destructive consequences. These, it should be recalled, include: (1) perversion of the institutions of representative government by removing the financial dependence of the government on the citizenry and making the citizens appear to be dependent on the government, (2) the consequent growth in the size of government, (3) the redistribution of wealth and income, which further contributes to the growth in the size of government through its creation of impoverishment, (4) the undermining of saving and capital accumulation, which has the same effect as the previous point, (5) increased hostility to profits and interest accompanied by the threat of price-and-wage controls and thus the chaos and tyranny of socialism, and, finally, (6) the likelihood of a renewed acceleration of inflation. This last not only would make all of the destructive consequences either that much worse or more likely, but would also open up the possibility of the destruction of credit and even of money itself. In its potential for bringing about the destruction both of the price system and of money (the former through leading to price controls and socialism), inflation, as we have seen, represents a longterm threat to the continued existence of modern material civilization. 121
This terrible dilemma, of having to choose between a catastrophic depression, on the one side, and the continual wearing down and ultimate destruction of modern material civilization, on the other, is what adoption of a 100-percent-reserve gold standard is capable of avoiding. It is, as I say, capable of ending inflation once and for all without precipitating a financial contraction or depression.
To understand just how this is possible, let us imagine that our present money supply of approximately $1,100 billion consisted of nothing but gold, and that this had been brought about by the government taking its gold holding of approximately 260 million ounces and pricing it high enough to make it equal to $1,100 billion. A price of something more than $4,000 per ounce would accomplish this. 122
Imagine that the government physically distributed this gold to the people: It called in all the paper currency and gave out very small gold coins in exchange; and it turned the remainder of its gold over to the banks, to place their checking deposits on a 100-percent-gold-reserve basis. 123 For the sake of maximum simplicity, we can think of the money supply as now consisting of 260 million one-ounce gold coins. (Obviously, much smaller denominations would be necessary, but let’s think of it this way.) Imagine that on one side of each of these coins it said “1 ounce of gold,” and on the other side “$4,000.” In the same way, imagine that all checking deposits were denominated both in terms of ounces of gold and in terms of dollars. The money supply could then be looked at as being either 260 million gold ounces or $1,100 billion. People would certainly want to hold this gold money supply very tightly, because the possibility of inflation would now have been definitively ended, since the money supply would actually be gold and thus there would physically be just no way for the government to increase it. People would hold the money not as dollars, but as pieces of gold.
Let us imagine that people wanted to hold this money supply so tightly that its velocity of circulation would be only 3. Thus, in terms of gold, GDP would be three times the 260 million ounces of gold, or 780 million ounces. In terms of dollars, however, the effect would be that GDP would plunge to little more than $3,000 billion (i.e., to $4,000 times 780 million), which is the very situation we wanted to avoid.
But now let’s make a change in our example. While the gold money supply remains at 260 million ounces and its velocity remains at 3—because it is gold that people are holding—let us see what happens if we assume a higher price of gold imprinted on each coin. Imagine that on the dollar side of each of the one-ounce gold coins that constitute the money supply, it said not “$4,000,” but “$8,000.” Observe. The gold money supply remains 260
GOLD VERSUS INFLATION 961 million ounces and the gold GDP remains 780 million ounces. But the dollar money supply now becomes $2,200 billion—twice as large. And the dollar GDP now becomes more than $6,000 billion—also twice as large. This $6,000 billion-plus GDP, of course, is the original size of GDP.
Now I am not in fact advocating a gold price nearly as high as $8,000 in today’s circumstances—for reasons that I will explain shortly. I used it just to illustrate an important point. And that is, that in principle it would be possible to stop inflation cold with a 100-percent-gold money, and simultaneously to offset the resulting fall in the velocity of circulation of money. This last would be accomplished by making the gold supply equal to enough dollars to leave spending in terms of dollars unchanged at the lower velocity. In other words, it is possible to stop inflation cold, and yet avoid the contraction in dollars spent that would otherwise result from a greater need and desire to hold money, simply by making the gold stock equal to a large-enough number of dollars. Thus the critical factor producing a depression following the end of inflation is overcome.
It cannot be stressed too strongly here how vital is the 100-percent-reserve-coin element if gold is to be used in this way. If the attempt were made to go to gold without this element, that is, with the government continuing to hold the gold and the people using paper, the effect of a sharply higher price of gold would merely be more inflation, and an actual increase in the velocity of circulation of money. For then, people would experience merely an increase in the quantity of paper dollars, which could be endlessly repeated. On the 100-percent-reserve gold-coin system, however, what people are holding is not dollars but physical gold. The velocity of money is then determined by the fact that the pieces of money are gold. The pieces of gold are held tightly and the number of dollars the pieces are called is then unable to affect the rate at which the money is spent.
Thus, one major aspect of the depression problem could be solved—the contraction in spending that results when inflation is stopped.
What about the other aspect—the excessive debt burden? The transition to a 100-percent-reserve gold-coin system would be able to solve that, too. If there were no other way to solve it, gold could simply be priced high enough to give people an actual sudden increase in their revenues and incomes calculated in dollars. In such circumstances, the transition to the system would be accompanied by the equivalent of a last burst of inflation. Thus, for example, if the problem of an excessive debt burden exists in the face of the initial $6,000 billion-plus GDP, the price of gold could be set at the point where the 780 million ounce gold GDP represents a $7,000 billion or $8,000 billion GDP or however high a dollar-GDP might be necessary.
Solving the problem of “an excessive debt burden” by means of inflation in any form is a reprehensible practice. Its only justification is the necessity of avoiding mass bankruptcies, which, given the inability of today’s judicial system to keep pace even with its current case load, would probably take a decade or more to get sorted out. That would mean that in the interval the economy would be largely paralyzed, because no one would know just who owned what. This must be avoided.
The effect of distributing most of the country’s gold to the banks, to place them on a 100-percent-reserve basis against their checking deposits must be explained. At present it would take about $700 billion in gold to do this, inasmuch as that is the amount of outstanding checking deposits. The transfer of this much gold to the banking system would represent an increase in its assets of approximately $640 billion, since its present standard-money reserves are little more than $60 billion. The addition of this much gold to the balance sheets of the banks, as reserves against their demand deposits, would permit them to take whatever writeoffs may be necessary on their existing loans and investments as the result of actual or likely delinquencies or failures on the part of their borrowers. To the extent that a substantial increase in the assets of the banking system remained, an equivalent portion of its holdings of government securities could be canceled.
Some further major positive effects of the transition to a 100-percent-reserve system would be that both the Federal Reserve System and the Federal Deposit Insurance Corporation could be abolished. They would both be rendered unnecessary and have no further function. 124
When one allows for the fact that there is privately owned gold in the United States, and that considerably more would have come in from abroad prior to having reached the point of establishing a 100 percent reserve (provided, of course, the necessary economic freedom had been established), it turns out that a conversion price in the neighborhood of $4,000 per ounce rather than $8,000 per ounce would probably be sufficient to maintain the preexisting level of spending in terms of dollars, even with a velocity of circulation of only 3. 125 I arrive at this figure on the basis of the highly conservative assumption of a world monetary gold stock of 2 billion ounces and the further assumption that the American economy represents about one-fourth of the world’s economy. As a result, I use a figure of 500 million ounces as the estimate of our potential total gold money supply. Assuming a gold velocity of 3, our gold GDP would thus be 1.5 billion ounces rather than 780 million ounces. Given today’s fiat-money GDP of $6,000 billion-plus,
962 CAPITALISM gold would have to be priced at around $4,000 per ounce to make it possible for the 1.5 billion-ounce gold GDP to represent an unchanged dollar GDP and thus avoid a contraction in dollar revenues and incomes. Next year, of course, when the quantity of fiat money and the GDP expressed in fiat money are higher, the appropriate gold conversion price would be higher.
As before, the principle is that to avoid a contraction of spending in terms of dollars, the conversion price of gold must be set in such a way that the prospective gold-ounce GDP of the country is made at least equal to the country’s GDP in dollars at the time the transition is to be made. 126
Unilateral movement toward the remonetization of gold by the United States might at some point attract a disproportionate share of the world’s gold stock. Also, a considerable burden could exist in producing the exports needed to import additional gold. Although this latter problem would be minimized through larger imports of gold while it is still relatively cheap (including imports in exchange for the sale of the kinds of government assets described earlier), a further problem could remain. Namely, the problem of the American economy becoming adjusted to the use of a disproportionate amount of the world’s gold, which was then followed by other countries going over to gold. At that time, the United States might begin experiencing substantial gold outflows—in effect suffering a kind of deflation in gold.
This leads to the conclusion that it would be desirable if the conditions for the remonetization of gold could be established internationally, with the simultaneous cooperation of as many of the world’s economically important countries as possible.
However, even if the United States alone moved toward the remonetization of gold, and did import a disproportionate share of the world’s gold supply, the loss to American citizens as individuals would be substantially less than under the fiat-money system. Under the fiat-money system, every year the great majority of individual citizens in effect import fiat money in exchange for goods or services. For the great majority of citizens finish the year with a larger holding of fiat money than they began it, and have had to trade away goods and services to do so. This is the withdrawal-of-wealth effect I described earlier. 127 It is the necessary outcome of increases in the quantity of money, which always end up in the cash holdings of the citizens. But unlike gold, whose supply increases only modestly from year to year, with fiat money there is no end to the process short of the destruction of the fiat money in a currency collapse. 128
If American citizens imported excess gold, not only would there be a complete end to that process, but they could probably count on later exporting the gold at a higher value, when foreign countries finally did come to move toward the remonetization of gold. Thus, their loss on this account would not be permanent. In fact, if they used most of any excess gold coming in merely to build up their gold holdings, and did not gear their normal financial activities to its presence, they would substantially benefit in the long run by their country being the first to move toward the remonetization of gold. This is because they would acquire gold at a relatively low value, when only they wanted it for more extensive monetary use, and then give it back to the rest of the world at a higher value, when everyone else also wanted it for such a purpose. And, not having geared their financial operations to its presence, they would not suffer substantial deflationary effects by virtue of its outflow.
The 100-Percent-Reserve Gold Standard, Liquidity, and the Dismantling of the Welfare State
The above proposal for the establishment of a full 100-percent-reserve gold standard in place of the present, fiat-money system has major implications for the dismantling of the welfare state—beyond the fact that it would compel the government to operate with a balanced budget. The fact that it would establish great financial liquidity, that is, large holdings of gold money relative to spending, and, of course, at the same time, reduce the burden of debt to manageable proportions, means that it would be possible radically to reduce the size of the government’s budget, and the scope of government activity, without fear of causing a depression and mass unemployment.
Under present monetary conditions, if government spending were substantially reduced, the effect would be a major problem of readjustment and would probably entail a depression. This is because under present monetary conditions, the debt structure stands like a house of cards and the least failure of demand anywhere in the economic system is capable of producing a wave of bankruptcies and bank failures. But it would certainly not be true if the economic system possessed the high degree of liquidity that a 100-percent-reserve gold standard could give it.
If firms possessed both substantially larger cash reserves and smaller debts relative to their revenues and incomes, they would be able to ride out the kind of temporary, localized failures of demand that would accompany slashing the government’s budget. They would be in a position of financial strength comparable to what existed in 1946.
It has been forgotten, but between 1945 and 1946—a period of just one year—federal government spending in the United States was reduced by more than 50 percent
GOLD VERSUS INFLATION 963
(from $93 billion to $46 billion) and more than ten million government employees—most of the army and navy—were dismissed! This was the conversion from the war economy to a peacetime economy.
At the time, many people feared that the result would be mass unemployment and a resumption of the depression. The actual effect was not unemployment, but a rapid and radical change in the type of employment. The millions of former soldiers and sailors and war workers quickly changed jobs and began producing goods and services of value to the lives and wellbeing of individuals. The net effect was simply an enormous rise in the standard of living.
All this was possible because the tremendous financial strength of the economy—indicated by a velocity of circulation of money of less than 2 in 1946—guaranteed that as government spending fell, private spending would increase correspondingly. For there was simply no need to build up liquidity any higher than it already was.
Transition to a 100-percent-reserve gold standard could achieve comparable financial strength today. On the basis of it, the American economic system could experience a far more dramatic improvement than it did in 1946. Then, improvement came because the United States was able to disband an American army that had fought on foreign soil in the defense of the United States. Today improvement would come from the disbanding of a virtual enemy army that operates on American soil against the American people—namely, the massive government bureaucracy that redistributes and consumes the American people’s wealth while doing its utmost to stop them from producing it. Disband this enemy army, and the output of goods and services in the United States will skyrocket.
Thus, the 100-percent-reserve gold-coin standard is a critical element in the economic reconstruction of the United States. It could stop inflation without depression and set the stage for the rapid and radical reduction of government activity.
Notes
1. For a typical instance of the treatment of inflation as caused either by “demand pull” or by “cost push” and the consignment of increases in the quantity of money to the demand-pull category, see Paul Samuelson and William Nordhaus, Economics, 13th ed. (New York: McGraw Hill Book Company, 1989), pp. 324–326.
2. See above, pp. 503–505 and 519–526.
3. See above, Figure 17–1, on p. 811.
4. The reader should note the parallelism here to my earlier refutation of the fallacy that falling prices caused by increased production constitute deflation. There, I showed that falling prices caused by increased production in the face of a fixed aggregate demand for goods do not reduce the ability of debtors to repay their debts because as the result of the same phenomenon that reduces prices—namely, the increase in supply—they have an inversely proportionate larger quantity of goods to sell at the lower prices. Thus it is no more difficult for them than it was before to earn any given sum of money with which to repay their debts. See above, p. 574. And, of course, to the extent falling prices increase real disposable income, the difficulty of repaying debt is actually reduced.
5. To some extent, creditors too might suffer a loss in the money value of their assets—namely, in cases in which value of the property destroyed exceeded the value of the owners’ equity. But on the whole the loss of the stockholder/debtors would be far greater.
6. See above, pp. 578–579.
7. This average unit cost, and the value of the capital as well, reflects the payment of wages no less than the purchase prices of capital goods.
8. The fact that reductions in supply would tend to be associated with a lower economic degree of capitalism and a lower degree of capital intensiveness means that if the process of capital decumulation and decline in production began subsequent to the date of the balance sheet of Figure 19–2, the total monetary value of the assets of the average business firm would be less in Figure 19–3 than in Figure 19–2. They would not be less only if the balance sheet of Figure 19–2 represented merely a point in an already established condition of capital decumulation and falling production, or if the capital decumulation and falling production were entirely the result of a fall in the productivity of capital goods rather than of a fall in the economic degree of capitalism and degree of capital intensiveness. 9. In Figure 19–1, the rate of profit and interest rise from 11.11 percent in Year 1 (i.e., 200 ⁄ 1,800 ) to 17.6 percent in Year 3 and thereafter (i.e., 300 ⁄ 1,700 ).
10. The very question of a transitional rise in the rate of profit relative to the rate of interest would not even come up insofar as capital decumulation and the fall in production were the result of a fall in the productivity of capital goods rather than in productive expenditure and the relative demand for capital goods.
11. This discussion closely parallels, mutatis mutandis, the discussion above, on pp. 817–818, concerning why no element of deflation is present in the fall in the rate of profit that results from a fall in the rate of net consumption and accompanies the early stages of the fall in prices that is caused by capital accumulation and economic progress. Also, in parallel with other discussion in the same place, it should be realized that any conceivable gain of business debtors at the expense of creditors resulting from a rise in the rate of profit would still not be the result of rising prices. If it could exist at all, it would be the result exclusively of the rise in the rate of net consumption and rate of profit, and would be capable of existing even if somehow there were no fall in production and supply and no rise in prices. 12. For a refutation of the fallacy that falling prices caused by increased production constitute deflation, see above, pp. 573– 580.
13. Indeed, as I will show, in order for inflation or deflation to exist, it is not necessary that changes in the price level actually
964 CAPITALISM exist at the moment. Changes in the price level are merely a symptom of inflation or deflation, not the phenomenon itself. The phenomenon itself can exist prior to and even in the absence of its symptoms, just as an illness can exist prior to and in the absence of its symptoms. On this subject, see below, pp. 921–922.
14. See above, the reference to Samuelson and Nordhaus for a typical textbook presentation of the demand-pull/cost-push doctrine.
15. See above, pp. 200–201.
16. See above, ibid.
17. On these points, see above, pp. 591–592.
18. See above, pp. 179–180.
19. See above, p. 229.
20. See below, pp. 931–933.
21. See above, pp. 899–901.
22. See above, pp. 518–519.
23. See above, Table 12–1, on p. 523.
24. See above, pp. 505–506.
25. On this subject, see above, pp. 829–831, and below, pp. 925–928.
26. See above, Table 12–1, on p. 523.
27. Rothbard originally used a similar definition. Cf. Murray N. Rothbard, Man, Economy, and State, 2 vols. (New York: D. Van Nostrand Company, 1962), 2:851. In his later, popular writings, however, he has come to use inflation as a synonym for rising prices.
28. On these points, see above, pp. 895–897.
29. Cf. Ludwig von Mises, Human Action, 3d ed. rev. (Chicago: Henry Regnery Co., 1966), p. 424. See also, idem, “Inflation and Price Control” in idem, Planning For Freedom, 4th ed. enl. (South Holland, Ill.: Libertarian Press, 1980), pp. 78–80. These pages also contain a valuable discussion of the semantic difficulties created by the definition of inflation as rising prices. 30. Cf. Ludwig von Mises “Planning for Freedom” in idem, Planning For Freedom, pp. 13–14.
31. See above, pp. 888–889. See also below, 940–941, which demonstrate an additional major deflationary consequence of government budget deficits.
32. At the same time, of course, because increases in the supply of gold are a by-product of increases in productive ability in general, the effect of any impairment of productive ability is a tendency toward a lesser rate of increase in the world’s overall supply of gold.
33. Just as deficits can exist without inflation, so inflation can exist without deficits. Inflation can exist even in the face of current government budget surpluses. It exists so long as the quantity of money is being increased at a rate more rapid than the increase in the supply of precious metals. If, while the government operates with a current budget surplus, the central bank or the private banking system buys up already outstanding government securities or acquires any other assets by means of such newly created money, there is inflation. Inflation existed under just such circumstances in the United States in the 1920s. 34. The threat of an absolute loss of gold reserves was diminished by virtue of the existence of National Bank notes and Federal Reserve notes, which served virtually to eliminate gold coin as a normal part of people’s cash holdings and thus the role of gold coin in day-to-day financial transactions. (See above, pp. 508–509.) To the extent that gold coin is used as currency, any creation of additional paper or checkbook money is automatically followed by redemptions of paper for gold, as people seek more gold coin to keep pace with larger holdings of money overall—much as they seek more bills of the various denominations when the supply of money increases. The elimination of gold coin as a significant component of the day-to-day money supply, served to limit the loss of gold reserves to the portion flowing abroad, until such time as the citizens might become alarmed about the situation.
35. See above, p. 510.
36. See the preceding note and above, p. 509.
37. See above, pp. 504–505.
38. See below, pp. 931–933. In addition, it should be realized that as far as government debt is held by the Federal Reserve System, the payment of interest by the Treasury is largely in name only, since much of the interest is turned back to the Treasury. What this refers to is the fact that when the Treasury pays interest on debt held by the Federal Reserve System, that interest is revenue to the Federal Reserve System on which, after deducting its expenses, the Federal Reserve System earns a profit. A major portion of this profit is then turned over by the Federal Reserve System to the Treasury, just as any other government enterprise must turn over most of its profits, if any. (The Federal Reserve System is in the highly unusual position for a government enterprise of having profits because its leading product—paper money—has virtually no cost of production.) Thus, in essence, what occurs is that one department of the government—the Treasury—pays interest to another department of the government—the Federal Reserve System—on loans granted out of newly created money, and then receives much of that interest back.
39. It should not be forgotten, of course, that the economy-wide average rate of profit and interest is high precisely because of the continued existence of substantial deficits, which have the effect of raising the rate of net consumption. On this point, see above, pp. 829–830.
40. Not surprisingly, under any of the proposals for a constitutionally balanced budget, the provisions could be evaded fairly easily.
41. A loss would be self-defeating because it would reduce the government’s ability to spend, while what the government wants is to increase its ability to spend.
42. See above, pp. 888.
43. See below, pp. 930–941.
44. For a critique of this fallacy, see above, pp. 573–580. 45. See above, pp. 876–878 and 887–888.
46. See above, pp. 890–891, 591–592, and 594.
47. See above, pp. 513–516 and 519–526. See also above, pp. 916–917, where the fact that inflation causes wage rates and prices to outrun the increase in aggregate demand is explained. 48. See below, pp. 938–942.
49. See above, pp. 891–892.
50. Cf. Adam Smith, The Wealth of Nations (London, 1776), bk. 5, chap. 3; reprint of Cannan ed. (Chicago: University of Chicago Press, 2 vols. in 1, 1976), 2:462–463.
51. Ibid. [2:461–466].
52. Ibid. [2:466–471].
53. See Ludwig von Mises, The Theory of Money and Credit,
GOLD VERSUS INFLATION 965 new ed. (Irvington-on-Hudson, N. Y.: The Foundation for Economic Education, 1971), pp. 414, 416.
54. See above, pp. 263–282.
55. See above, pp. 282–294.
56. See Human Action, pp. 412–414. See also Henry Hazlitt, Economics in One Lesson, new ed. (New Rochelle, N. Y.: Arlington House Publishers, 1979), pp. 168–169.
57. Cf. above, pp. 554–555, where this phenomenon is discussed in relation to the doctrine of consumptionism.
58. See below, pp. 942–946.
59. See above, p. 768 and pp. 837–838. The material in the second reference explains how the conversion of savings into hoards raises the rate of net consumption.
60. See above, pp. 925–927.
61. On this subject, see below, pp. 942–950.
62. See above, p. 229.
63. Concerning such gravitation, see above, pp. 737–739. 64. On these points, cf. von Mises, Human Action, pp. 549–550. 65. See below, pp. 935–936, for a demonstration of the fact that the loss of the lender is actually substantially greater than the gain of the borrower in cases of this kind.
66. See above, pp. 520–521.
67. Cf. Human Action, pp. 550–566.
68. See above, pp. 622–636.
69. See above, p. 929. See also above, p. 555.
70. Cf. Human Action, pp. 548–550, 556.
71. See above, pp. 744–750, on the nature of this relationship. 72. On these points, see above, pp. 618–642.
73. See above, pp. 632–634.
74. See above, pp. 683–685 and 694–696
75. These cash reserves, of course, do not leave the economic system but return to business firms. On average, a business firm ends up with the same cash it had before, but it does so in an environment in which the volume of its financial transactions is greater. Thus, its cash reserves fall relative to the volume of its financial transactions.
76. Concerning all four of the mechanisms by which a more rapidly growing quantity of money reduces the demand for money for holding and thus raises the velocity of circulation of money, see above, pp. 519–522.
77. See above, pp. 513–514.
78. As a general principle, the deflationary effect of the inflation of paper money hinges on the gold value of the paper falling in greater proportion than the increase in the supply of paper money and thus the increase in the volume of spending that takes place in terms of paper money. This outcome is virtually certain inasmuch as the market takes into account in the present all of the prospective future decline in the value of paper money expected to result from inflation in the future.
79. Cf. Human Action, pp. 797–798.
80. See above, pp. 591–592.
81. See above, p. 591.
82. This does not mean that I advocate simply that the government abandon its policy of inflation in the context of our present monetary system. Such a step, taken by itself, would result in a catastrophic deflation and depression, probably worse than that of 1929. A disaster of this magnitude must certainly be avoided. It can be avoided if the abandonment of inflation is coupled with a transition to a 100-percent-reserve gold standard. On this subject see below, pp. 959–962.
83. See above, pp. 937–938.
84. Cf. Henry Hazlitt, Man vs. The Welfare State (New Rochelle, N. Y.: Arlington House, 1970), pp. 147, 148.
85. Cf. Human Action, pp. 426–428. See also Ludwig von Mises, Stabilization of the Monetary Unit—From the Viewpoint of Theory, chap. 1, in Ludwig von Mises, On the Manipulation of Money and Credit, trans. Bettina Bien Greaves, ed. Percy L.Greaves, Jr. (Dobbs Ferry, N. Y.: Free Market Books, 1978), pp. 3–16.
86. See above, pp. 520–521. See also above, p. 906.
87. Calculations based on data appearing in Federal Reserve Bulletin, October 1986, p. A13, and March 1989, p. A13. 88. See above, p. 924.
89. On the subject of credit crunches, see above, pp. 939–940. Concerning profit squeezes, see above, p. 943.
90. For the explanation of why not, see above, pp. 931–933. 91. See above, ibid.
92. In the discussion that follows, I frequently refer to the U. S. government rather than to the Federal Reserve System, which is merely the specific government agency charged with the formulation and execution of the government’s monetary policy. I attach no great significance to the Federal Reserve’s alleged independence from the government. It is, as I say, a government agency. The members of its board of governors are all nominated by the president and confirmed by the Senate. All must stand for periodic reappointment. All are subject to various political pressures. For example, many, if not all, can be assumed to have joined in various political alliances and incurred various political debts in the course of their careers prior to their appointment, debts which they can be called upon to repay during their tenure in office. In addition, of course, Congress can at any time change the law under which the Federal Reserve operates, something to which the Federal Reserve Board is very sensitive.
93. For the most part, it doesn’t even actually have to create very many of those billions—its demonstrated willingness to create them is sufficient. For example, the government could create all the billions of paper currency necessary to redeem all the bank deposits in the United States. But it will never actually have to redeem any very major portion of those deposits so long as it demonstrates its willingness to do so whenever put to the test.
94. See above, this page, n. 87.
95. Calculation based on data appearing in Federal Reserve Bulletin, March 1989, p. A13.
96. Calculations based on data appearing in Federal Reserve Bulletin, March 1989, p. A13; ibid., April 1993, p. A14. 97. Calculations based on data appearing in Federal Reserve Bulletin, April 1993, p. A14, and July 1994, p. A14.
98. As previously noted in Chapter 12, n. 34, this calculation is based on year-end data appearing in Federal Reserve Bulletin, July 1994, p. A14, and weekly money supply figures as reported in New York Times, October 17, 1994.
99. See above, pp. 520–521, for the explanation of why increases in the quantity of money raise the rate of interest rather than reduce it.
100. By way of a postscript to the discussion in the text, I must observe that as of the early spring of 1995, the international currency markets are confirming this view. The precipitating
cause seems to be the failure of the new, Republican-controlled Congress to enact a balanced-budget amendment to the Constitution, and the interpretation of this fact as signifying continued rapid growth in the U.S. national debt and a corresponding longterm need to inflate in order to service the debt. In response to such anticipations, there is a tendency in the world market to liquidate assets denominated in dollars, and use the proceeds to purchase assets denominated in other currencies, which, for the time being, are believed to have less inflationary prospects.
As a further postscript, as this book goes to the printer in the spring of 1996, it has become clear that since the end of 1993, an important development has occurred with respect to what should be counted in the M 1 money supply. Over this time, general-purpose and broker-dealer money-market-mutual-fund accounts have rapidly become indistinguishable from ordinary checking accounts, in that requirements limiting the frequency with which checks may be written on these accounts, as well as requirements limiting the minimum-sized check that may be drawn on them, have both been rapidly disappearing. In the absence of further research, it is not possible to determine the precise amount of growth in the money supply for which this development has been responsible in the last two years. But taking it as equal merely to the increase in these accounts over this time, the effect on the rate of increase in the money supply has been substantial, even if one includes in the money supply at the end of 1993, the totality of such accounts rather than merely the fraction of them that was already the equivalent of checking accounts at that time.
Based on the data in the Federal Reserve Bulletin of March 1996, p. A14, the effect of recalculating the growth in the reported M 1 money supply in this way is that the percentage change between December 1993 and December 1994 becomes 3.2 percent instead of 1.7 percent, and the percentage change for 1995 becomes +4.1 percent instead of -2.2 percent. The significance of such recalculation is that it makes intelligible what would otherwise be an extremely puzzling phenomenon indeed. Namely, how the economic system could be displaying signs of inflation in the midst of fairly sustained outright deflation.
101. See above, pp. 141–144.
102. Concerning the origin of money, see above, pp. 506–508. 103. Roman Civilization Sourcebook II: The Empire (New York: Harper & Row, 1966), p. 440.
104. Ibid., pp. 441–442. This was like insisting today that a $20 gold coin be used as the equivalent of only $20 of paper money. 105. See James Breasted, Ancient Times, 2d ed. (Ginn and Company, 1967), p. 747.
106. On this point, see above, pp. 510–511 See also below, pp. 951–954.
107. This, of course, is the process of good money driving out bad money. For reconciliation of this fact with Gresham’s Law, according to which bad money drives out good money, see above, pp. 510–511.
108. Henceforth, for the sake of brevity, I generally refer to gold alone. But the same points apply to silver as well.
109. One method of estimating the proper conversion price is simply to divide the government’s existing gold stock into the money supply. Currently, this means dividing approximately 260 million ounces of gold into $1,128 billion of money. The resulting conversion price is thus $4,340 per ounce. When the monetary role of silver is allowed for, however, a figure of closer to $3,000 results. Concerning this last, see below, pp. 958–959.
110. On the subject of the monetary unit as a unit of weight of precious metal, see Murray Rothbard, What Has Government Done to Our Money? (Novato, Calif.: Libertarian Publishers), 1974, pp. 5–7.
111. See above, pp. 573–580 and 817–818.
112. See above, pp. 762–767, 774–775, 807–818, and 825–826. 113. See above, p. 574 and pp. 744–750, 762–771, and 882–883. 114. See above, pp. 519–526 and 938–940.
115. Recognition of the fact that a greater demand for money for holding increases the real stock of money and, indeed, is the only thing that can do so, can be found in Rothbard, What Has Government Done to Our Money?, pp. 15–16. See also above, pp. 693–694.
116. This figure follows from the fact that total checking deposits were approximately $799 billion, while bank reserves of standard money were approximately $61 billion. See Federal Reserve Bulletin, July 1994, pp. A13, and A14.
117. Ibid., p. A29.
118. On the subject of parallel standards, see Rothbard, What Has Government Done to Our Money?, pp. 17–19.
119. This section is largely a revised version of my article “Gold: The Solution to Our Monetary Dilemma,” which appeared in the Bulletin of the US Paper Exchange, June 1980, and was subsequently reprinted in The Intellectual Activist, October 1 and November 1, 1980.
120. See Federal Reserve Bulletin, July 1994, pp. A14, A51. 121. See above, pp. 263–278, for explanation of the ways that price controls and socialism destroy material civilization. 122. For the sake of simplicity, we ignore the role of silver. 123. I am indebted to Murray Rothbard for this pattern of achieving a 100-percent-reserve gold standard, which he first presented in an unpublished monograph in the mid-1950s. 124. Ibid.
125. When the monetary role of silver is allowed for, the conversion price works out to closer to $3,000 per ounce. 126. In certain circumstances, compliance with this principle might require that the government use less than its full gold stock to redeem the supply of paper currency and fiduciary media. For example, if the U.S. government today possessed 500 million ounces of gold by itself, the conversion price implied by devoting all of it to the redemption of the money supply would be only $1,500 per ounce. This would make the gold-ounce GDP, and the volume of spending it implies, the equivalent of too few dollars to comply with the principle. In such circumstances, the government could devote less than its full gold stock to the redemption of the outstanding money supply, and use the remainder in redeeming a portion of the national debt. In other circumstances, of course, the government’s gold stock might be so limited that it would be necessary to increase it before making the conversion.
127. See above, pp. 936–937.
128. The additional holdings of gold on the part of the citizens have the further distinction at least of representing an additional supply of a physical commodity, which is capable of making some actual contribution to human wellbeing.
Capitalism: A Treatise on Economics
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