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Why Prices Have Not Skyrocketed
By Paul Nathan As we
know the fed created huge sums of money in order
to shore up the balance sheets of financial
institutions. The assumption by many then as now
is that this would lead to a burst of inflation.
So, why aren't prices skyrocketing? Off the top
of my head and standing on one foot I will try
to answer that question.
For the purpose of this discussion I will define
inflation as too much money chasing too few
goods resulting in an across the board increase
in prices. Credit is a derivative of money and
must also be considered since it is also a claim
on goods. Deflation would be the exact opposite:
Too little money and credit chasing too many
goods leading to falling prices. The definition
was originated by Milton Friedman, more as a way
of simplifying an understanding of inflation for
the laymen than as a serious theory of the value
of money. That he did elsewhere.
The Quantity Theory Of Money, or Monetarism, is
the accepted monetary theory of our day. Most
investors, economists, and political pundits,
and probably you yourself, hold that a major
increase in money and credit is inflationary and
will inevitably lead to higher prices. Irving
Fisher formalized the theory in the 20's and
Milton Friedman expounded on the theory in the
70's. His clear and simple way of explaining the
nature of inflation was grasped easily by
professionals and laymen alike. Milton Friedman
almost single handedly waged and won the war
against inflation during the 70's, a period when
we needed him most. This is why I list Milton
Friedman as one of those that had a profound
influence on me not only in economics, but as a
writer. But I am not a Monetarist. Monetarism is
not wrong, it is simply incomplete.
There is another theory of money that challenges
the Monetarists theory of money that I believe
makes a lot more sense -- one that explains why
we are not experiencing a lot higher prices
given the huge increase in the money supply. It
is the Subjective Theory of the value of money
as formalized by Ludwig Von Misses and the
Austrian School of Economics. This theory holds,
in its simplest form, that money derives its
value not from the quantity in circulation, but
the value individuals place on money in exchange
for other goods.
What always leads to price rises or price
declines is the hoarding or dishoarding of money
by the population at large. Increases in the
money supply can influence the value people
place on money but it is only one factor in
calculating the future value of money. The
Monetarist School sees an increase in money as a
cause of higher prices, where the Austrian
School does not. In the end it is the actions
individuals take themselves based on their value
of money that lead to higher prices, according
to the Austrian School.
If Ben Bernanke dropped dollars from helicopters
tomorrow, Friedman would say that inflation
would result. Von Mises would say it would
depend on what individuals did with the money
and to what degree. If they put it under their
mattress no inflation would occur. If they spent
it, Monetarists would compute the amount of the
increase in new money and predict an inflation
rate based on the percentage of increase in the
quantity of money. Von Mises would suggest that
it is just as likely that all money previously
created would loose value as individuals loose
confidence in all paper claims that serve as a
medium of exchange. He, I believe, would
conclude that hyperinflation was more possible
than progressive inflation; that a breakdown of
the monetary system would be more likely than a
discounting of the value of money leading to
progressively higher prices. Zimbabwe is good
example of that.
At any time individuals decide to suddenly save
rather than spend, prices tend to fall
irregardless of the quantity of money in
circulation. Whenever individuals decide to
increase their spending sharply and suddenly,
prices tend to rise. The Monetarist theory of
money only partially explains the phenomenon of
inflation and deflation. It was very correct in
the 70's within that particular context. It is
not doing so well in present day America as the
context has completely changed.
In the 70's the Federal Reserve printed vast
amounts of money that went directly into
consumption. Today the fed has printed vast
amounts of money that has gone directly into
savings by financial institutions. The fed
dramatically increased the money supply
beginning in September 2008. According to
Friedman, prices should respond within 9 to 12
months. So we should have seen a marked increase
in prices by the fourth quarter of 2009. We did
not. In January we saw a 2.6 year over year
increase in the CPI and the core rate actually
declined for the first time since the early
eighties.
Many economists suggest that we do not have an
inflation problem now but we will a year or two
from now. I know of no theory that can project
prices several years in advance. Those that are
suggesting higher prices are inevitable sometime
in the future are simply guessing. There is no
causal link. The fact is, the money supply was
increased from 1 trillion three hundred and
seventy five billion dollars to one trillion
seven hundred and 6 billion from 9/15/08 to
12/29/08. If I'm not mistaken that is the
largest increase in money supply by the US
Federal Reserve, ever. Yet, inflation has
remained low.
What those arguing that prices will rise sharply
in the future are actually saying is that when
the money that the fed printed begins to be used
for consumption, we will have an inflationary
problem. This would be true if and when it
happens. But this is the Austrian School's view
of the world, not the Monetarists.
If all of a sudden, for whatever reason, people
begin to dishoard money, its value will fall and
prices will rise. It is human action that
dictates prices not the quantity of money. Most
point to gold and other hard commodities vrs.
fiat money all over the world over the last many
years as signs of inflation. The value of most
currencies have fallen in relation to gold as
individuals dishoard paper money and hoard gold
and most other commodities. But, this is not
inflation. Consumer prices have remained stable.
That is because the new money created is not
chasing goods. Fiat money has been targeted
towards gold and other assets. This suggests
that an increase in the money supply is "not
always and everywhere" inflationary. It does not
always lead to a general across the board
increase in prices. It may show up elsewhere
such as stocks, real estate, or commodities --
or it may not show up at all.
The Subjective Theory Of Value does not dispute
the fact that if a government prints up
progressively more and more money and throws it
into circulation the monetary unit will probably
fall in value. It usually does -- but not
always. The cause and effect is not one of
increased money equals increased prices. It is
that a change in human action that values money
less leads to increased prices.
The distinction is an important one. It goes to
the heart of today's monetary argument. Is
inflation based on the single act of increasing
the money supply? Or is it based on how
individuals perceive its increase and how they
act on it? I come down on the side of Von Mises
on the subject. If a majority of people today
believed their money was going to depreciate by
50% next year in terms of goods, in my book, (or
should I say Von Mises's book -- which happens
to be called Human Action) they would begin
discounting the monetary unit today. My
conclusion is that they do not believe that.
Prices have risen in the last year, but there is
no panic out of currencies in relation to goods.
And interest rates, the price of money, have
remained stable rather than soaring to discount
future depreciation.
Monetarists will argue that it is just a matter
of time. That the newly printed money will
eventually start chasing goods and bid up
prices. Yet, that is not the expectation of the
markets. Markets know there is not "too much
money or credit chasing too few goods". The bond
market confirms this and long term inflationary
expectations have remained in check. This could
all change in a matter of minutes, but it would
not have to do with the quantity of money. If
prices did begin to increase dramatically a vast
increase in the quantity of money could not be
the trigger -- that trigger has already been
pulled. It would be due to a sudden change in
individual perceptions of the value of money
going forward -- and this is never predictable.
The big difference between Monetarism and the
Subjective Theory Of Value is the first believes
it can predict inflation or deflation. The
latter knows it can not.
Even during the gold standard there was
inflation and deflation. It was usually due to
unexpected gold strikes or unexpected economic
contractions. The gold standard served the
nations of the world well for centuries. Money
remained fairly stable. There were many sharp
depressions but they were over quickly and they
were within the context of continuous and
dynamic growth. The years of the gold standard
were the years of the Industrial Revolution.
Sir Issac Newton, one of the smartest men who
ever lived, helped establish and preserve the
gold standard during the mid 1600's. Some of the
greatest minds in England's 17th century such as
Adam Smith and John Locke continued to champion
the gold standard which ushered in their
Industrial Revolution. The Founding Fathers, no
slouches in their own right, established the
gold standard as the monetary system of the
United States Of America and wrote it into the
US Constitution. It was the monetary system that
led to the American Industrial Revolution. But
Woodrow Wilson decided he knew better than most
of the greatest minds that ever lived, and
discarded the gold standard and replaced it with
the edicts of the Federal Reserve Board.
You don't have a monetary system that lasts
centuries because it is ineffective. True, we
had a lot of economic normal ups and downs, but
the worst of those downturns lasted only a short
time, not a decade as did the Great Depression
or the malaise of the 70's. More importantly,
the value of money always stayed fairly constant
during those years which is all that the gold
standard guarantees. It never guaranteed
economic Utopia. Under the fiat standard we have
lost 98% of our money's value since the
government replaced the gold standard with the
Federal Reserve System and to this day we still
have panics and severe recessions.
For sure, we know that in all things monetary
and economic, context changes and today is no
exception. Today, I am less concerned about
progressive inflation and more concerned that
the fiat standard we have established is
failing. Many are calling for fundamental
monetary reform. But, from this point it would
be easier to improve the fiat system than to
replace it. (See my article "Are The Fiat And
Gold Standards Converging" by clicking "more
articles" at the top of this page.) Fiat
currencies all over the world are loosing
confidence. Gold is reflecting this.
A medium of exchange must be a medium of trust
to be a lasting medium. Money must be
dependable. The artificial increase in the money
supply by governments undercuts that trust. This
is the case today. But it is not the fed that is
the real threat, it is irresponsible politicians
in general.
Inflation has been held in check by the
knowledge that money can be pulled out of the
system as fast as need be under a fiat standard.
The real threat is the viability of the entire
world fiat system. If trust is to be regained it
needs to start with fiscal responsibility.
Monetary policy is far "easier" to control by an
independent authority than is government
spending by a world of spendthrift politicians.
The debt that has been created by most nations
today is a far greater threat to the economy
than the threat of inflation. Monetary reform is
required, I agree, but not today. It is fiscal
reform that is required.
No monetary system, not the fiat standard nor
the gold standard can survive reckless tax and
spending policies by government. Our first task
is not fighting inflation. Our first task is
reigning in deficit spending and addressing
unfunded liabilities. Without addressing those
problems a mere increase in prices -or decrease
- is dwarfed by the potential of a prolonged
recession such as has occurred in Japan over the
last two decades and the toll that would take on
this country. Or worse a chain reaction of debt
defaults that could bring the entire
international monetary system tumbling down.
It is important to keep an eye on inflation, and
deflation, and the fed, and the dollar. But I
suggest that we as a nation, indeed, we as a
world, need to sharpen our focus and deal
immediately with government spending, government
debt, government entitlements, and tax policy.
Long before any action need be taken on monetary
reform to reign in inflation we need to address
our fiscal problems. No monetary reform will be
meaningful or lasting without fiscal sanity. I
suggest we stop wagging our fingers at the
Federal Reserve and redirect them toward those
that want to spend more on government programs
with no way of paying for them. |