Why the Deflationist Argument Is Wrong in Both Theory and Practice
Nov. 27, 2009
Ludwig von Mises wrote this in Human Action (1949).
3. At any rate, a monetary expansion results in misinvestment of capital and overconsumption. It leaves the nation as a whole poorer, not richer. These problems are dealt with in Chapter XX.4. Continued inflation must finally end in the crack-up boom, the complete breakdown of the currency system.
5. Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.
A debate has gone on for over 35 years: Austrian School economists and analysts who predict price inflation vs. non-Austrian School analysts who claim to be Austrian and who predict price deflation.
For the entire period, the consumer price index, January to January, has never declined. This goes back to 1955. This fact has had no effect on most deflationists. They remain deflationists.
The deflationists argue that the size of America's debt -- private and government -- is too large for Federal Reserve monetary policy to keep from collapsing in a wave of uncontrollable defaults and price deflation.
Their central argument has not changed ever since a self-proclaimed Austrian School (he wasn't) former central banker (he was: Ceylon), John Exter, began pushing the following argument in the early 1970s. They argue as follows: no matter how much the Federal Reserve adds to the monetary base, it cannot get frightened commercial bankers to lend money. This will keep the increase in the FED's balance sheet -- the monetary base -- from being translated into M1: real money. Therefore, debt will "implode," forcing down prices at Great Depression-era rates of decline. From 1930 to 1933, they argue, the money supply fell by a third. So did prices. This or worse will happen again.
The deflationists do not understand these crucial facts:
1. the FED is 100% in control over the size of M1.
2. The FED has chosen to imitate post-1990 Japan.
3. Japan has has not had a year since 1990 in which consumer prices fell into negative territory by as much as 2%.
4. The money supply shrank in the Great Depression because 9,000+ banks failed.
5. The government passed the FDIC law in 1934.
6. The money supply has not shrunk since then.
Let us look at these facts. (Note: they are facts. They are not theories.)
1. The FED is 100% in control over the size of M1.
The deflationists argue that the FED can pump up the monetary base by purchasing assets, but it has no control over the size of M1, which is the real money supply. This is because M1 depends on commercial banks making loans, thereby taking advantage of all those extra reserves that the FED's newly created reserves make available. The commercial banks instead deposit the money with the FED as excess reserves. So, M1 has not grown to match the more than doubling of the monetary base. The FED therefore has no control over M1. It cannot control what bankers do with available reserves.
This is the deflationists' bottom line: "The FED cannot force bankers to lend money." This is so utterly nonsensical that it boggles the imagination. The FED could get every banker in the country to pull back all excess reserves ($1 trillion these days) tomorrow and lend the money. It does not have to issue an edict. It does not have to take over the banks. All it has to do is charge 10% per annum on all excess reserves. Probably 1% would do the trick.
Banks are paid zero interest on these excess reserves today: whatever the federal funds rate pays. Federal funds are overnight bank-to-bank loans: the shortest of short-term loans.
Banks must make their money from lending, and a trillion dollars are not making banks any money today. If the FED imposed a fee (a negative interest rate), the banks would all lose money -- big money -- on their excess reserves.
The FED could experiment at the rate required. It could keep raising the "digit-storage fee" until the banks had no more excess reserves on deposit. This would double M1. This would double most prices. Simple. No compulsion. No directives. Just raise the price of not lending until banks are fully lent out.
This is so obvious that only a self-blinded deflationist refuses to see it, acknowledge it, or reply to me. I have been pointing out this out potential strategy for months. On September 18, I wrote:
The FED can get banks lending again simply by charging banks a storage fee on their excess reserves. Put differently, the FED pays negative rates. At some point -- probably around 1% -- the banks will pull their money out of their excess reserves account and lend it to the Treasury at 0.1%. That's a better rate than negative 1%.There is no problem with getting banks to lend -- nothing that a 1% negative interest rate would not cure in 24 hours. If I am wrong, then the FED can hike the fee to 2%.
The FED's problem is this: as soon as the banks pull out their money and start lending, the fractional reserve process takes over. The doubling of the FED's monetary base, September to December, 2008, will lead to a doubling of M1 and a move of the M1 money multiplier into positive territory.
We would get mass inflation, then hyper-inflation. The FED has no intention of getting either one. So, it pays banks 0.1% on their excess reserves, leaving Keynesians to get all in a dither over the liquidity trap and zero-bound interest rates.
They refuse to respond . . . all of them. That is because, logically, there is no answer. So, all of them are playing "Let's pretend." Let's pretend there is no economic logic. Let's pretend that no one has mentioned this obvious policy. Let's pretend that an increase of the Federal Reserve balance sheet has nothing to do with the money supply. Let's pretend that Murray Rothbard was pathetically shortsighted when he wrote his textbook on money and banking in 1983, The Mystery of Banking. He just did not understand that deflation is inevitable. Poor Rothbard. All that brainpower, so little understanding!
Here is my advice:
Until a deflationist responds specifically to my argument, using both the logic of profit and loss (commercial bankers' self-interest) and the logic of fractional reserve banking as presented by Rothbard and all other trained economists, you should dismiss the entire deflationist position as crackpottery.
The deflationists can run, but they can't hide . . . from basic economic logic.
2. The FED has chosen to imitate post-1990 Japan.
The Japanese government and central bank allowed the largest banks to keep bad loans (toxic assets) on the books for almost two decades. The banks have not lent. They have hoarded reserves. This has protected them from bankruptcy. Sound familiar? Of course. This is what the FED has done. It swapped Treasury debt for toxic assets at face value in late 2008 -- a subsidy of hundreds of billions of dollars. This was for big banks only. It is letting small banks fail, to be absorbed by larger banks, with the FDIC absorbing the losses.
3. Japan has has never had a year since 1990 in which consumer prices fell into negative territory by as much as 2%.
Prices in Japan have not risen or fallen much in any year. They have remained close to flat, overall, for over 17 years. Some years slightly up; some years slightly down; but no overall change. See for yourself. This chart is published by the Federal Reserve Bank of St. Louis.
Because prices were rising by 2% oer year in mid-2008, the recent reversal to nagaive 1% constitutes a fall, from rising prices to price deflation. But if we look at the rise and fall of consumer prices since 1992, consumer prices have not fallen to negative 2% in any year.
"Wait," you say. "This isn't what the deflationists have said. They told us that Japan has suffered from deflation for years." They have, indeed. They lie. That's right. Lie. As in "let's put the shuck on our readers, who will not look up any of this. Let's scare them with the bogeyman of price deflation. We'll sell subscriptions!" And they have.
Don't trust anyone who has ever told you that Japan has suffered systemic price deflation. For a year or two, yes. But not cumulative, and not systemic.
Any productive economy should have falling prices. This is healthy. This is what the United States had in its most productive era, 1865-1900, before the Federal Reserve System. Prices were falling. Then came the FED.
4. The money supply shrank in the Great Depression because 9,000+ banks failed.
This chart shows what happened to small banks, 1929-1933.
The bankruptcy of banks shrank the money supply by contracting credit extended by banks. The fractional reserve expansion of the 1920s imploded. This is what the Austrian theory of the business cycle says will happen to a fractional reserve system in which the government or the central bank does not bail out the commercial banks, thereby allowing M1 to shrink.
5. The government passed the FDIC law in 1934.
With the creation of the FDIC, banks ceased to fail. That kept the credit system, which means bank loans in M1, from shrinking. So, Federal Reserve policy, which had been expansionary after 1929, was translated into increased money.
This chart shows what happened to the money supply after the FDIC was created in 1934, and banks ceased to fail.
6. The money supply has not shrunk since then.
We know what happened after 1961: consumer prices rose more than seven-fold. You can trace this by using the inflation calculator that is made available by the Bureau of Labor Statistics.
DELIBERATE POLICY
The Federal Reserve has more that doubled the monetary base since September 2008. This saved the big banks. It is not saving the small banks.
The FED has reversed its previous policy of not paying interest on reserves. This took place on October 6, 2008. The press release is here.
Congress had authorized this, but it was not to begin until 2011. The FED without warning advanced the date by three years. As the press release said:
The Financial Services Regulatory Relief Act of 2006 originally authorized the Federal Reserve to begin paying interest on balances held by or on behalf of depository institutions beginning October 1, 2011. The recently enacted Emergency Economic Stabilization Act of 2008 accelerated the effective date to October 1, 2008.
This was self-conscious policy. This can be dated as the beginning of the FED's Japan solution. The Japan solution involved big bank bailouts, the reduction of commercial bank lending, and permanent economic stagnation. This was the FED's alternative to triple-digit monetary inflation (M1) and triple-digit price inflation.
This policy suits the FED well. Big banks stay solvent. The mortgage market can be funded without hyperinflation. Prices remain flat (as in Japan). The economic recovery is postponed. The economy is "steady as you go." Unemployment rises, but the FED does not get blamed. It gets praised by almost economists and the financial media.
CONCLUSION
Deflationists argue that the Federal Reserve is powerless to stop price deflation. This argument is utter nonsense. It has been utter nonsense since John Exter began promoting in in 1973 (or earlier).
The FED has engineered the present system: a bailout of Fannie Mae and Freddie Mac, a bailout of the big banks, and flat consumer prices -- neither price inflation or price deflation. The sign that this was deliberately planned was the FED's decision to pay interest on reserves three years early. The New York Federal Reserve Bank has published a staff report showing that this policy is deliberate. Read it here:
The FED is not sitting helplessly, as the "forces of deflation" overwhelm its policies. It has designed these policies, implemented these policies, and is getting credit for having saved the world economy.
The deflationist argument is illogical. Ir denies what all schools of economic opinion have argued, namely, that the Federal Reserve can control the money supply through its balance sheet, so long as the failure of commercial banks is not allowed to shrink the deposit base. The FDIC has guaranteed this since 1934.
Keynesian economists have cried "wolf" about price deflation ever since 1936. Hard-money non-economists began pitching this utterly nutty story in the early 1970s. Martin Weiss only abandoned it late this year, after 27 years. The pro-gold non-economists who say they are Austrian economists are self-deluded. They refuse to accept Rothbard's analysis in The Mystery of Banking. They refuse to follow Mises in his analysis of the hyperinflationary crack-up boom, which he said central banks can create and will create unless they cease increasing their purchase of assets.
Do not listen to them. They do not know what they are talking about. They do a great song & dance, but it is all shuck & jive.
Most of all, when they tell you they are Austrian School analysts, do not believe them. They are anti-Austrian on the money and banking issue, no matter what they say. They are so poorly trained in Austrian School economics that they do not understand that they are anti-Austrian.
The Federal Reserve may at some point pull back from the brink of hyperinflation and stabilize money, thereby causing Great Depression 2. I hope it does. The alternative is the breakdown of the division of labor. If it does back away, this will be deliberate policy.
Anyone who argues that a central bank cannot create hyperinflation at any time is an economic ignoramus. He may be a widely quoted guru. He may use fancy jargon. He may present a bunch of formulas that neither he nor you understands. He does not know what is is talking about. Ignore him.
It took Martin Weiss 27 years to figure this out. Don't wait for some recently arrived deflationist guru to figure it out.
[Note: If some deflationist guru respomds to this article on his Website, but fails to provide a link to this article, so that his readers can see what I actually wrote, you will know he has no answer, other than "Mumble, mumble, mumble, jargon, jargon, jargon. Therefore, deflation is inevitable!"]