Chapter I

THE TWENTIETH CENTURY HAS been the century of omnipotent government. In some countries, totalitarian governments have established themselves in one stroke through revolutions—apparently a bad strategy, for none of these governments exists any more. But in other countries, totalitarianism has not sprung into life full-fledged like Venus from the waves. In the United States and in virtually all the western European countries, government has grown slowly but steadily, and if unchecked this growth will make it totalitarian one day, even though this day seems to be far removed from our present.

Fact is that in all western countries the growth of government has been faster over the last one hundred years than the growth of the economy. Its most conspicuous manifestations are the welfare state and of the warfare state.¹ Now the growth of the welfare-warfare state would not have been possible without inflation, which for the purposes of our study we can define as the growth of the supply of base money and of financial titles that are redeemable into base money on demand.² The production of ever-new quantities of paper dollars and the creation of ever-new credit facilities at the Federal Reserve have provided the “liquidity” for an even greater expansion of bank-created demand deposits and other money substitutes, which in turn allowed for an unparalleled expansion of public debt. U.S. public debt is currently (December 2002) at some 6.2 trillion dollars, up from under 2 trillion at the beginning of the 1980s, and less than 1 trillion before the era of the paper dollar set in when President Nixon closed the gold window in the early 1970s.

The link between the paper dollar and the exponential expansion of public debt is well known. From the point of view of the creditors, the federal government controls the Federal Reserve—the monopoly producer of paper dollars—and it can therefore never go bankrupt. If necessary, the federal government can have any quantity of dollars printed to pay back its debt. Buying government bonds is thus backed up with a security that no other debtor can offer. And the federal government can constantly expand its activities and finance them through additional debt even if there is no prospect at all that these debts will ever be paid back out of tax revenues. The result is seemingly unchecked growth of those governments that control the production of paper money.

Among the many causes that coincided in bringing about this state of affairs is a certain lack of resistance on the part of professional economists. In the present essay I will deal with a wrong idea that has prevented many economists and other intellectuals from fighting inflation with the necessary determination. Most economists backed off from opposing inflation precisely when it was needed most, namely, at the few junctures of history when the inflationary system was about to collapse. Rather than impartially analyzing the event, they started fearing deflation more than inflation, and thus ended up supporting “reflation”—which in fact is nothing but further inflation.³

The United States of America has experienced two such junctures: the years of the Great Depression and the little depression we are facing right now in the wake of the first global stock market boom. Today again, the deflationary collapse of our monetary system is a very real possibility. In November 2002, officials of the Federal Reserve (Greenspan, Bernanke) and of the Bank of England (Bean) proclaimed there would be no limit to the amount of money they would print to fend off deflation. These plans reflect what today is widely regarded as orthodoxy in monetary matters. Even many critics of the inflationary policies of the past concede that, under present circumstances, some inflation might be beneficial, if it is used to combat deflation. Some of them point out that there is not yet any deflation, and that therefore there is no need to intensify the use of the printing press. But on the other hand they agree in principle that if a major deflation set in, there would be a political need for more spending, and that, to finance the increased spending, the governments should incur more debts and that the central banks should print more money.⁴

Such views have a certain prominence even among Austrian economists. Ludwig von Mises, Hans Sennholz, Murray Rothbard, and other Austrians are known for their intransigent opposition to inflation. But only Sennholz did not flinch from praising deflation and depression when it came to abolishing fiat money and putting a sound money system in its place. By contrast, Mises and Rothbard championed deflation only to the extent it accelerated the readjustment of the economy in a bust that followed a period of inflationary boom. But they explicitly (Mises) and implicitly (Rothbard) sought to avoid deflation in all other contexts. In particular, when it came to monetary reform, both Mises and Rothbard championed schemes to “redefine” a paper currency’s “price of gold” to restore convertibility.⁵

The main weakness of this scheme is that it implies that the reform process be directed by the very institutions and persons whom the reform is supposed to make more or less superfluous. It is also questionable whether our monetary authorities can legitimately use “their” gold reserves to salvage their paper money. In fact, they have come to control these reserves through a confiscatory coup, and it is therefore not at all clear how plans for monetary reform à la Mises and Rothbard can be squared with the libertarian legal or moral principles that Rothbard champions in other works.

But there is also another issue that needs to be addressed: what is actually wrong with deflating the money supply, from an economic point of view? This question will be at center stage here, which can fortunately build on Rothbard’s analysis of deflation, which demonstrated in particular the beneficial role that deflation can have in speeding up the readjustment of the productive structure after a financial crisis. But no economist seems to have been interested in further pursuing the sober analysis of the impact of deflation on the market process, and of its social and political consequences. The truth is that deflation has become the scapegoat of the economics profession. It is not analyzed, but derided. One hundred years of pro-inflation propaganda have created a quasi-total agreement on the issue.⁶ Wherever we turn, deflation is uniformly presented in bad terms, and each writer hurries to present the fight against deflation as the bare minimum of economic statesmanship. Economists who otherwise cannot agree on any subject are happy to find common ground in the heart-felt condemnation of deflation. In their eyes, the case against deflation is so clear that they do not even bother about it. The libraries of our universities contain hundreds of books splitting hairs about unemployment, business cycles, and so on. But they rarely feature a monograph on deflation. Its evilness is beyond dispute.⁷

Yet this silent accord stands on shaky ground. A frank and enthusiastic endorsement of deflation is, at any rate in our time, one of the most important requirements to safeguard the future of liberty.

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¹In the American case, the warfare state has been a more powerful engine of government growth than the welfare state; see Robert Higgs, Crisis and Leviathan: Critical Episodes in the Growth of American Government (New York: Oxford University Press, 1987).

²With this definition we follow Murray N. Rothbard, Man, Economy, and State, 3rd ed. (Auburn, Ala.: Ludwig von Mises Institute), p. 851, who defines inflation as an increase of the quantity of money greater than an increase in specie. While Rothbard’s definition fits the case of a fractional-reserve banking system based on a commodity money standard, our definition is meant to fit the specific case of a fiat money standard with fractional-reserve banking. Both definitions deviate from the most widespread connotation of the term, according to which inflation is an increase of the money price level. The latter definition is not very useful for our purposes, because we intend to analyze the causal impact of changes in the supply of base money (which is at all times subject to political control).

³For the purposes of our study we will define deflation as a reduction of the quantity of base money, or of financial titles that are redeemable into base money on demand. Again, this deviates from the usual connotation of the term, which defines deflation as a decrease of the price level. But as the reader will see, our analysis will cover both phenomena—deflation in our definition and a decrease of the price level. The point of our definition is merely to render our analysis more suitable for practical application. A monetary authority at all times can prevent deflation in our definition, while it can at times be unable to prevent a decrease of the price level, even by pumping great quantities of base money into the economy.

⁴See for example the columns and editorials by journalists with a hard-money reputation such as Steve Forbes in the U.S. and Stefan Baron in Germany. The same message emanates from the publications of otherwise reasonable economists such as Jude Wanniski and Norbert Walter. A symptomatic essay is Norbert Walter, “Is the Global Recession Over?” Internationale Politik (Transatlantic Edition, fall 2002): 85–89.

⁵See Hans Sennholz, The Age of Inflation (1979), chap. 6; Rothbard, Man, Economy, and State, pp. 863–66; idem, America’s Great Depression, 5th ed. (Auburn, Ala.: Ludwig von Mises Institute, 1999), pp. 14–19; Ludwig von Mises, “Die geldtheoretische Seite des Stabilisierungsproblems,” Schriften des Vereins für Sozialpolitik 164, no. 2 (1923); idem, Theory of Money and Credit (Indianapolis: Liberty Fund, 1980), pp. 262–68, 453–500; idem, Human Action, Scholar’s Edition (Auburn, Ala.: Ludwig von Mises Institute, 1998), pp. 564f.; Murray N. Rothbard, The Mystery of Banking (New York: Richardson and Snyder, 1983), pp. 263–69; idem, The Case Against the Fed (Auburn, Ala.: Ludwig von Mises Institute, 1995), pp. 145–51. Mises and Rothbard adopted the point of view espoused already by Jean-Baptiste Say, who depicted deflation as a harmful practice of restoring monetary sanity after a period of extended inflation. See Jean-Baptiste Say, Traité d’économie politique, 6th ed. (Paris, 1841); translated as A Treatise on Political Economy (Philadelphia: Claxton, Rensen & Haffelfinger, 1880). For a critical survey of the opinions of Austrian economists on deflation, see Philipp Bagus, “Deflation: When Austrians Become Interventionists” (working paper, Auburn, Ala.: Ludwig von Mises Institute, April 2003).

⁶The main engines of the propaganda have been the state universities of the West, as well as an exaggerated faith in the authority of monetary “experts” in the service of the IMF, the World Bank, the Federal Reserve, and other government agencies charged with the technical details of spreading inflation. Is it really necessary to point out the non sequitur implied in granting expert status in matters monetary to the employees of these organizations? An obvious parallel is the case of the economists on the payroll of labor unions who, because “labor” unions pay them, are considered to be experts in labor economics. Clearly, if one called labor unions “associations for the destruction of the labor market”—which most of them are by any objective standard—the expertise of their employees would stand in a more sober light. The same thing holds true for those writers on monetary affairs who happen to be on the payroll of the various associations for the destruction of our money. This is of course not to deny that there might be good economists working for the IMF or the Federal Reserve. Our point is merely that their qualification to speak on the issue is not at all enhanced by their professional affiliation. Quite to the contrary, given the incentive structure, we would have to expect that good monetary economists only accidentally find their way to these institutions.

⁷The outstanding modern theoretician of deflation is Murray N. Rothbard. As we have stated above, Rothbard’s views on deflation seem to be deficient only when it comes to the practical issue of monetary reform. An overview of the essential tenets of Austrian deflation theory is in Joseph T. Salerno, “An Austrian Taxonomy of Deflation” (working paper, Auburn, Ala.: Ludwig von Mises Institute, February 2002). Among the few non-Austrian works that analyze deflation without undue emotional bias, see John Wheatley, An Essay on the Theory of Money and Principles of Commerce (London: Bulmer & Co., 1807), in particular Wheatley’s discussion of Lord Grenville’s plan for monetary reform on pp. 346–57; Lancelot Hare, Currency and Employment, Deflation of the Currency—A Reply to the Anti-Deflationists (London: P.S. King & Son, 1921); Edwin Cannan, The Paper Pound of 1797–1821, 2nd ed. (London: King & Son, 1925); Yves Guyot, Les problèmes de la deflation (Paris: Félix Alcan, 1923); Guyot, Yves and Arthur Raffalovich, Inflation et déflation (Paris: Félix Alcan, 1923).