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The Fed Fights Deflation
The chattering classes have lately taken up a chorus of worry that our economy is experiencing too little inflation for its own good. The Greenspan Fed has announced that having battled the demon inflation to a stand they would now take up their cudgel against the much more fearsome foe, deflation.
Heaven forefend, think I, what cruel God would curse our industry and virtue with stable prices? How lucky we are that the wise and noble Fed governors will undertake a mission for which they have shown great talent and zeal, destruction of the dollar.
Straight-faced, the Fed governors claim to have been too successful in their fight against inflation. When the Fed got going in 1913 prices hadn’t changed much in the previous 100 years. Gold was money and everybody knew that “bills” were just that, paper claims for gold, payable on demand. All banks printed notes, i.e. promises to pay, but if the bank printed too many, people started asking for their gold and the problem went away.
Since the Fed started watching over the dollar, it has shrunk to the value of a 1913 nickel. If this is a victory, what would a defeat look like? If deflation can indeed be stopped by inflating the money supply, the Fed is the surely outfit to do it.
It should be simple. Just crank up the money supply at the proper rate and deflation will end. Blessed rising prices will return. But life and inflation are not as simple as central bankers would have us believe. Both are freighted with paradox and ironic justice. Women don’t mean what they say. No garment ever makes a man’s wife look fat. Owning dot com stock would make you rich ten years ago and poor today.
Inflation on a grand scale has a paradox of its own and a satisfying logic. The paradox of paper money is that once created out of “thin air” it eventually will return there. Printing cash is the old fashioned way to inflate. In modern economies most money is borrowed into existence. It is a wonderfully efficient way to create money, but it is also the ultimate problem of such a system. If the Fed only inflated by printing bills, it would have complete control over the supply of money. But in our financial system, just about anyone can create new money. The gnomes of the Fed have much less control than they will admit.
Every credit transaction, except the lending of cash, creates money out of thin air. That’s what makes banking so delightfully profitable. Others know this and create money too. Car dealers, furniture retailers, businessmen who carry receivables, homeowners who take back second mortgages, people buying pizza with a Visa card all create money from nothing. The paper promise to pay is an asset for the lender, a fully negotiable note. Notes are money.
One of the hardest ideas to grasp, like the infield fly rule, is that new money is not new wealth. The world’s supply of golf balls, cigars and beer doesn’t go up when new money is created, only their price does. But having more inflated money makes everyone feel richer, even as we become poorer.
Expanding credit creates the illusion of wealth. People and businesses start living as if they were wealthy. Borrowed money, invested wisely in productive enterprise can make you richer. But too often new money is spent on stuff like boats, cars, sushi, or thousands of shares of reallydumbidea.com. Easy money is often squandered.
All this magically created money must eventually disappear because all loans eventually must be either repaid or repudiated. When a credit loan is repaid the money it represents vanishes the same way it appeared. Credit money also disappears when a loan goes into default. A mountain of money disappeared when Enron went belly-up. Dead loans often languish on a lender’s books for a while, but eventually they are either paid off or written off. Either way, the money disappears. The money supply shrinks by the amount of the original loans.
For inflation to continue indefinitely in a credit based money system, borrowing must continue in ever increasing amounts. Congressmen and politicians stand ready to borrow on your account whatever vast sums may be necessary to buy the votes they need. They are making a Herculean effort even now to keep the money game going, borrowing and spending on your behalf like drunken Centurions.
Businesses and individuals on the other hand, have to stop borrowing at some point. We can be enticed but not compelled to borrow. When the borrowing stops, deflation will follow and prices will fall.
The economists at the Fed know all this, but you will never hear any of them admit it. Banks and the federal government love inflation because, like counterfeiters, they get to use the new money first. Constantly inflating the money supply is like collecting a hidden tax from all those to whom the money is passed on. Deflation is the natural and unavoidable redeployment of all the misallocated resources that inflation caused. The Fed’s efforts to fight it will only delay and worsen the eventual readjustment.
Falling prices do not cause recessions any more than cold temperatures cause winter. Central banks, governments, businesses and ordinary folks like you and I, when we finally get sucked into the game, cause recessions by buying things we can’t afford with money we don’t have from people we don’t like. Such behavior will get us what we deserve rather than what we expect, but it won’t prevent falling prices or produce a lasting prosperity.