Chapter VII

INFLATION IN THE FORM of fractional-reserve banking and fiat money is ultimately a self-defeating practice. It bears in itself the germs of its own destruction and, as we shall see, deflation is the essential vehicle of this destruction. We can distinguish three scenarios of the halt of inflationary processes:²⁴

First, there can be a liquidity crisis of the fractional-reserve banking system that ends up in a bank run, that is, in a sharp decline of the demand for money substitutes. The concomitant drastic reduction of the money supply entails a corresponding decrease of money prices, which negatively affects all market participants who have financed their operations through debt. The lower nominal selling receipts after the run do not suffice to pay back the debts contracted at the higher nominal price level of the past. This in turn jeopardizes the positions of many creditors, who when they do not get their money back cannot pay back their creditors. Thus the liquidity crisis of our fractional-reserve banks entails a general financial meltdown. Rock bottom is reached, in a commodity money system, when all money substitutes have vanished and the market participants have turned to using the money commodity itself or use competing currencies, for example, other commodities or foreign paper monies. After the deflation has cleaned up the economic landscape, fractional-reserve banking and other forms of financial intermediation will play a less significant role in the economy. Firms and individuals will, at the margin, turn to financing whatever purchases they make through personal savings. In short, financial decision-making will be even more conservative and more decentralized than before.

This first scenario was very common in the nineteenth century and up to the Great Depression, which, according to Irving Fisher and the early Chicago School, was all about debt-deflation entailed by a liquidity crisis of fractional reserve banking. The scenario became less important after the introduction of deposit insurance, which for all practical purposes established 100 percent reserve banking in the U.S.²⁵ It could have some relevance, however, in explaining the more recent financial crises in Russia, Brazil, Argentina, and certain Asian countries, in particular if the currencies of these countries at the time of the crisis could be interpreted as money substitutes for U.S. dollars.

Second, there can be intertemporal misallocations of resources when fraudulent fractional-reserve banks increase the money supply and thereby depress market interest rates below their equilibrium level. Then entrepreneurs invest too many of the available resources high up in the physical production chain, and not enough resources in the lower stages of the structure of production. The result becomes visible after some time, when a more or less great number of firms must file bankruptcy. This in turn jeopardizes their creditors, in particular fractional-reserve banks, and leads to the chain of events we described above. The difference between the second and the first scenario is in the causation of the bank run. In the former, the bank run starts more or less by accident, when one major market participant—be it out of negligence or due to unforeseeable contingencies—fails and pulls down a house of cards. By contrast, in the scenario we are now considering, the bank run is the necessary consequence of a previous misallocation of resources that resulted from a fraudulent increase of the money supply.

The question is whether this scenario applied to any historical crisis is somewhat controversial. Many Austrian economists believe it fits the Great Depression and several other economic crises of the past. At any rate, it is certainly a conceivable scenario, and it also involves a heavy dose of money-substitute deflation. Hence, in this scenario too inflation ends up in a deflationary meltdown of the old ways of finance. The share of banking and financial intermediation in overall economic activity will be reduced, and financial decision-making will be even more conservative and decentralized than it is anyway.

The two foregoing scenarios both involve a more or less sudden decline of the demand for money substitutes, which entail a more or less rapid physical disappearance of these substitutes from circulation, as market participants switch to using base money. By contrast, in the case of paper money, it is very unlikely that there will ever be a rapid deflation in our definition—a reduction of the money supply. The reason is that paper money is protected through legal tender laws and other legislation. That leaves barter as the only legal alternative to using paper money, and barter is so much less beneficial than monetary exchange that market participants typically prefer using even very inflationary monies rather than turning to barter. In all known cases, it was only under extreme duress—when the purchasing power of their paper money holdings dwindled within hours, so that indirect exchange became impracticable—that the market participants finally ignored the laws and started using other monies than the legal tender.

The foregoing three scenarios cover probably most historical cases in which inflation has been brought to an end. If we tie this up with our comparative analysis of free and compulsory production of money and money substitutes, we come to the conclusion that deflation is not a mere redistribution game that benefits some individuals and groups at the expense of other individuals and groups. Rather, deflation appears as a great harbinger of liberty. It stops inflation and destroys the institutions that produce inflation. It abolishes the advantage that inflation-based debt finance enjoys, at the margin, over savings-based equity finance. And it therefore decentralizes financial decision-making and makes banks, firms, and individuals more prudent and self-reliant than they would have been under inflation. Most importantly, deflation eradicates the re-channeling of incomes that result from the monopoly privileges of central banks. It thus destroys the economic basis of the false elites and obliges them to become true elites rather quickly, or abdicate and make way for new entrepreneurs and other social leaders.

It is highly significant that the authors of the 1931 Macmillan Report, which analyzed the worldwide financial crisis of the time, recognized and emphasized that deflation was foremost a political problem. They clearly saw that deflation brings down the politico-economic establishment, which thrives on inflation and debts, and that it therefore brings about some circulation of the elites. The late Lord Keynes and his coauthors—among them several leaders of the London banking industry, and of the British cooperative and labor-union movements—were of course convinced that their country could not do without them.²⁶

Deflation puts a brake—at the very least a temporary brake—on the further concentration and consolidation of power in the hands of the federal government and in particular in the executive branch. It dampens the growth of the welfare state, if it does not lead to its outright implosion. In short, deflation is at least potentially a great liberating force. It not only brings the inflated monetary system back to rock bottom, it brings the entire society back in touch with the real world, because it destroys the economic basis of the social engineers, spin doctors, and brain washers.²⁷ In light of these considerations, deflation is not merely one fundamental policy option next to the fundamental alternative of re-inflation. Rather, if our purpose is to maintain and—where necessary—to restore, a free society, then deflation is the only acceptable monetary policy.

The case of Japan might serve as a warning counter-example. The severe Japanese recession of the early 1990s was both an economic and a political threat to the establishment. In Japan, the process of consolidation and centralization of power started right after World War II, when the “economic experts” within the U.S. occupation forces imposed Keynesian and socialist policies on their former enemy. By the late 1980s, the process had advanced to such an extent that it was politically impossible to allow deflation to cleanse the economy and politics. The Japanese governments of the 1990s sought to “fix” the economic crisis through increasingly heavy doses of inflation. But the only result of this policy was to give a zombie life to the hopelessly bureaucratic and bankrupt conglomerates that control Japanese industry, banking, and politics.²⁸ After almost fifteen years of mindless inflation, Japan’s economic crisis has turned into a fundamental political crisis that sooner or later will bring the country onto the verge of revolution.

This is also what will happen to the West, if the citizens of our countries let their governments have a free hand in monetary affairs.

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²⁴See Jörg Guido Hülsmann, “Toward A General Theory of Error Cycles,” Quarterly Journal of Austrian Economics 1, no. 4 (1998). Fractional-reserve banking melts down whenever, and for whatever reason, a sufficiently big number of bank customers decide to demand redemption of their deposits. Any increase of the quantity of money can engender a sequence of boom and bust, if (a) the new money first reaches the capital markets and if (b) the entrepreneurs do not anticipate that the new money will lead to a rise in prices over the level they would otherwise have reached. The erroneous calculations of the entrepreneurs lead them to shift resources from sustainable investment projects into ones that cannot be completed with the available quantities of factors of production. And the erroneous calculations are also reflected in (not caused by) a below-equilibrium interest rate. When the market participants discover their errors, the more or less large number of unsustainable firms goes bankrupt, thus upsetting the balance sheets of the banks and entailing a financial meltdown.

²⁵Notice that in the Great Depression deflation was not allowed to complete its work. The Fed inflated the economy after deflation had destroyed a great number of banks, reducing their total number to some 15,000—roughly the level prevailing in 1900. These select few, protected by federal deposit insurance, then surfed on the Fed-created inflation and expanded their total assets from 51.4 billion in 1933 to 242.6 billion dollars in 1957. See R.W. Burgess, ed., Historical Statistics of the United States, Colonial Times to 1957 (Washington, D.C.: Bureau of the Census, 1960).

²⁶See “Committee on Finance and Industry Report” (London: His Majesty’s Stationary Office, #3897, 1931). On the concept of circulation of elites, see Vilfredo Pareto, Manuel d’économie politique (Geneva: Droz, 1966), chap. 2, §§ 103–07 and chap. 7, §§ 19–21; translated as Manual of Political Economy (New York: Augustus M. Kelley, 1971).

²⁷On the cultural implications of inflation see Paul A. Cantor, “Hyperinflation and Hyperreality: Thomas Mann in the Light of Austrian Economics,” Review of Austrian Economics 7, no. 1 (1994).

²⁸On the efforts of the ruling party (LDP) to bail out and prop up its allies in agriculture, banking, and construction industries, see the report of the Economist Intelligence Unit: Country Profile Japan (London: The Economist, 2001). For an interesting attempt to explain the current crisis in Japan as a “structural trap” rather than as a mere monetary liquidity trap, see Robert H. Dugger and Angel Ubide, “Structural Traps, Politics, and Monetary Policy” (working paper, Tudor Investment Corporation, May 2002). See also Edward Lincoln, Arthritic Japan: The Slow Pace of Economic Reform (Washington, D.C.: Brookings Institution, 2001). On the general issue of economic-political sclerosis see Mancur Olson, The Rise and Decline of Nations (New Haven, Conn.: Yale University Press, 1984).