Wall Street remains constantly worried about two forces in American economic life: inflation and deflation. It seems Wall Street worries about inflation on Mondays, Wednesdays, and Fridays. On Tuesdays and Thursdays, it worries about deflation. Or perhaps it worries about both at the same time.

Of course, inflation is one of the most destructive forces in all of human history. In order for an economy to function properly, money must be sound and its value must be honestly gained. For most of human history, soundness and honesty were guaranteed because money was just another name for the most valuable commodity: gold. Gold was ideal as money because it was portable, durable, divisible, fungible, and scarce.

Gold has been money throughout most of our nation’s history, and until well into the 20th century government had little control over its supply and value. But with the establishment of the Federal Reserve in 1913, the foundation of money in gold began to be eroded. Over the decades, the link became progressively less secure, until in 1971 President Nixon did away with the last remnants of the gold standard. If you hid a dollar in a mattress in 1970, today it would be worth less than a quarter of its former value.

Why? Our nation’s monetary authorities have conducted a 35-year scam against the sound dollar, and the result has been theft on a grand scale. In fact, the government has extracted more from us in inflation than it has in tax increases over this same period. The demise of the gold standard is what made this extortion possible.

No Limits on Fed

Under a gold standard, there are strict limits on how much money can be created. But under the paper money standard, there are no limits. The government and the banking cartel can determine how much paper money to print, and thus how much to water down the value of money. The Fed is all-powerful with regards the creation of fiat money, and the only real restraint on it is fear of a backlash from the financial community.

Wall Street rarely takes the long view. So when inflation worries begin to dominate the market, it is not the fear of what further monetary depreciation might mean to American families that is the primary concern. Rather, traders are worried that the Fed might raise interest rates in an effort to counter inflation tendencies. Higher interest rates mean less borrowing, less credit expansion by the banking system, and a potential end to the decade-long party on Wall Street. Despite the recent stock market rebound, it would only take an uptick of one point in short-term interest rates to cause even the most convinced Wall Street bull to rethink his life.

And what about the threat of deflation? This term, which hadn’t been heard in public for many years, started being tossed about last year, when the price indices first recorded a drop in selected consumer and producer prices. A common assumption is that deflation leads to lower profitability, and possibly even recession or depression. Is this true? A good way to tell is to set aside macroeconomic data like the consumer and producer price indices, and look at a particular industry. Do falling prices necessarily spell economic doom? Consider the price of computer hardware, for example. For 20 years computer prices have fallen steadily even as quality has risen, with vast improvements in computer speed and memory capabilities. Yet throughout all of this, the computer industry is still among the most profitable.

The truth about deflation is quite the opposite of what you read on the financial pages. Falling consumer prices typically signal rising prosperity, just as they did in the latter half of the 19th century. In fact, if we had a truly free market coupled with a gold standard, falling prices would become the norm. You might be able to keep that dollar in your mattress and pull it out 25 years later to discover that it had more purchasing power than when you first squirreled it away. Sadly, this is not the case today. Even in the midst of all this talk about deflation, we have yet to see any kind of secular slide in prices that has lasted longer than a few weeks.

The start of the Great Depression is typically attributed to the falling price levels of the 1930s, as if this were a cause of general economic downturn. In fact, falling prices were the one aspect of the Depression that helped mitigate the effects of a deep productivity crash brought about by government intervention in the price system. Falling prices meant that dollars were becoming more and more valuable over time. But Washington, in its infinite wisdom, worked for the better part of a decade to pump price levels back up again, thereby insuring that the real cause of the Depression would not be addressed, and that unemployment would continue at a high level.

The Great CPI Controversy

Early in the second term of the Clinton Administration, Treasury and Fed officials began to wonder whether the indices being used to calculate inflation were really telling the truth. They announced that they were pretty sure the Consumer Price Index (CPI) was overestimating price inflation by as much as two points.

Now, consider what this would mean. The Bureau of Labor Statistics (BLS) employs thousands of people to do nothing but examine prices paid for goods and services at all levels. They calculate data from every conceivable source and present it in myriad ways to the public. But somehow along the way, said the Clinton Administration through its expert, Stanford University’s Michael Boskin, mistakes are being made. They are overestimating inflation.

In justifying his own opinion, Boskin spent less time explaining his methodology than in attacking BLS’ own. He pointed out that it doesn’t make much sense to aggregate prices that are stable and fixed — say those of commodities — with those that change because of technological shifts or changes in relative scarcities. For example, what if someone decided to calculate the ten-year price inflation rate using three goods: private school tuition, handheld calculators, and gasoline. Tuition has gone way up, calculator prices have gone down, and gasoline prices have not changed much. He might end up with an index number of zero. Yet that conceals an enormous amount of information. And let’s say he wants to throw into this index the price of real estate in Manhattan. He would likely get a soaring rate of inflation. As we can see, indices can be highly misleading.

Boskin is right that the price inflation rate is highly dependent on precisely what is in and what is out. And it is difficult to adjust for price changes that come about from technology. The basket of goods that is included in the CPI is constantly changing, not because science necessitates this, but because the BLS watches politics very carefully, and politics necessitates that government always generate a lower inflation figure than is probably accurate.

The purpose of all this data collection is to discover the mysterious thing called the price level. But in reality there is no such thing as a price level. Prices do not move up and down like the sea, but are often unpredictable. Inflation (an increase in the money supply) causes most of them to rise, but calculating that rise is a very tricky business. The only thing we can know for sure about inflation is that it waters down the purchasing power of our money, and does so in an insidious and deadly way.

Money Manipulation

Economists who favor monetary manipulation have good reason to talk about prices instead of purchasing power. Such talk helps distract attention away from the real cause of inflation: the Federal Reserve adding to the stock of dollars in the economy by artificial means. The Fed can do this in three ways: lowering the discount rate; buying assets on the open market; and lowering the reserve ratio on bank deposits.

When the Fed was set up just before World War I, it was designed by the banking and corporate elites with one purpose in mind: to make possible a more elastic currency. The Fed cartelized the banking system and allowed for coordinated inflation and credit expansion. It cut the necessary minimum reserve requirements, provided added bailout guarantees, and allowed banks to pyramid loans on top of Fed reserves. This was a tremendous benefit to the banking industry, and to the government which needed financing in World War I. But it forecast disaster for the soundness of U.S. currency.

Despite the Fed’s fingerprints, for most of the second half of this century, a debate has raged about who precisely is to blame for inflation. This debate usually begins with the assumption that if one party is not to blame, it is the Federal Reserve. It is not only Alan Greenspan who has a reputation as a great inflation fighter, but every previous Fed chairman. They are all described in the usual monetary histories as hard-nosed opponents of inflation. But how can this be? There is only one force that can cause the purchasing power of existing dollars to systematically decline, and that force is an expansion of the existing dollar stock through artificial means. There is only one power on earth that brings that about: the Federal Reserve.

The loss of the value in the dollar benefits debtors, and there is no bigger debtor than the federal government. An elastic currency permits the expansion of debt to a huge extent, and makes it possible for the government to be the one and only entity that can make an ironclad promise to make good on its debts. Thus, their bonds carry no risk premium. They will always be paid, but always at someone else’s expense.

Not that the Fed has always intended to bring about large-scale monetary depreciation. They can set out to expand credit without warrant, and to grow the money supply to bring about an economic boom. But the consequences of those actions are not felt immediately and they are not always predictable. Moreover, the Fed is always anxious to separate itself from the effects of its policies.

Thoughts on Inflation

There are several schools of thought on whether inflation is good or bad for the economy. The first is the Keynesian School, which has generally celebrated inflation as a means of bringing markets back into equilibrium when they have been thrown out by the business cycle. In the Keynesian theory, you can reduce unemployment by increasing inflation, or you can reduce inflation if you are willing to tolerate higher unemployment.

Of course, this tradeoff is completely mythical. There is no fixed relationship between inflation and unemployment. Developments of the mid 1970s, in which inflation and unemployment moved up together, dealt a substantial blow to the theory. And today we have witnessed dramatic declines in both.

But historically Keynesian economic theory has been well supplemented by a leftist theory favoring redistribution of all wealth — especially taking from producers and giving to non-producers. Inflation does this, along with taxation and the welfare state. It punishes savers and rewards debt. This is why egalitarians have always celebrated inflation, and why you are more likely to hear the case for inflation being made by a socialist than a believer in free enterprise.

Yet not all backers of inflation favor redistribution and leftism. The supply-siders are big on the need for tax cuts. But if you look at the works of Jude Wanniski, the op-eds of Alan Reynolds, the politics of Jack Kemp, or the recommendations offered on the editorial page of the Wall Street Journal, you see a single fallacy repeated again and again: Economic growth must be backed by monetary growth. Or put in an even more dangerous phrase: Restrictive money growth holds back economic growth. This is merely another version of the old fallacy that prosperity can come from the printing press.

In a slightly different way, the Chicago School advocates a fixed rate of growth for the money supply, neither undershooting nor overshooting the rate of economic growth and thereby achieving a stable price level. But as noted earlier, the notion of a stable price level is unachievable. The very nature of prices is that they adjust up and down to reflect changes in resources, tastes, and technology.

So this supposed ideal of stable money is not only impossible to achieve, but it robs people of the purchasing power of their money. The monetarist plan also imposes a kind of collateral damage on the economy for which the theory doesn’t take account. All new money injections distort the pricing signal of the interest rate. They cause some industries to undertake borrowing and business expansion they would not otherwise undertake. The new money works as a subsidy to some kinds of projects, but not to others. As a result, even the monetarist proposal sets in motion an artificial boom in some sectors of the economy.

Monetarism can be particularly dangerous in periods of deep recession, when economists of this school typically recommend gunning the money supply. But gunning the money supply does nothing to correct the underlying structural problems that lead to business downturns in the first place. What an economy in recession needs more than new money is time — time to clean out bad investments, time for wages to adjust, and time for the investment sector to align itself with the spending and savings sectors.

But what we are discussing here relates more to business cycles than inflation. And in order to understand them both, we need a more complete view of the monetary side of the economy. That is where we turn to the writings of Murray Rothbard, Ludwig von Mises, F.A. Hayek, and the Austrian School of Economics in general. For most of this century, the Austrian School has fought against monetary depreciation and for the gold standard. Only the Austrian School accurately predicted the consequences of fiat money and warned about the cause and effect of inflation.

Too Big to Fail?

The Federal Reserve has long considered the banking system to be too big to fail. But consider the crises that Fed Chairman Alan Greenspan has been called upon to help deal with over the last several years. Greenspan intervened in 1987 to pull the stock market up from failure. He has intervened several times since then to bolster buying in the bond market and in the commodity futures market. During the Mexican peso crisis, he committed resources from the Fed to prop up the investments of U.S. banks in Mexico, and then later combed the halls of Congress to push for the peso bailout. Finally, he has been the major force behind arguing for an expansion of the International Monetary Fund (IMF), along with an implicit promise to bail out the IMF should its resources run dry.

In effect, Greenspan has instituted a too-big-to-fail doctrine for Wall Street and even whole governments. The consequence of this has been to dramatically subsidize the risks of traders and governments. They can safely assume a bailout will be forthcoming and this expectation causes them to act more recklessly. It is difficult to imagine a more dangerous move on the part of any central banker.

As for Americans, we should enjoy whatever deflation we can get right now. The government should not try to sustain high prices on any goods or services, but rather let them fall. That will allow us to prepare for a time when the dollar faces a challenge as the world reserve currency, and the effects of the monetary expansion of the last ten years come home to roost.

If we want to eliminate inflation forever, we can resecure the dollar to its historical foundation in gold and suppress the issuance of any more artificial money and credit. We could also separate the monetary regime from the state entirely, and build a fire wall between the dollar and politics.

Until then, we should not become sanguine about the prospects of inflation, but prepare ourselves not only for another bout, but for the shock that comes with the realization that the laws of economics have not, after all, been repealed.

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