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Painting Itself Into a Corner / Artikel mises.org
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<font color="#002864" size="1" face="Verdana">http://www.mises.org/fullstory.asp?control=1225</font>
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<font face="Verdana" size="2"><font color="#002864" size="5"><strong>Painting Itself Into a Corner</strong></font>
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<font size="4">by Frank Shostak</font>
<font size="2">[Posted May 13, 2003]</font>
<font size="2">
<font size="2">It seems that the Fed is signaling to the market that it is
shifting from its traditionally advertised role of fighting inflation to
fighting deflation. Most experts, including Fed officials, are of the view
that deflation is a much greater menace than inflation and therefore deserves
special attention.</font>
<font size="2">It is held that a fall in prices, which is termed deflation,
causes consumers to postpone their buying of goods and services. In short, if
people hold on to their money during deflation its purchasing power will
increase and this will enable them to buy more goods some time in the future.
It is for this reason, so it is held, that people choose to spend less once
prices are falling. </font>
<font size="2">It is further believed that since consumer spending is
almost 70% of GDP this means a cut in consumer spending would slow down the
economy. A slower economy in turn, would cause businesses to retrench labour,
increasing unemployment and slowing consumer spending further. All this
intensifies the economic slump and depresses prices further. According to this
way of thinking, falling prices set in motion a vicious downward spiral that
spreads economic havoc.</font>
<font size="2">The usual examples cited are the U.S.
1930's Great Depression and the current Japanese economic slump. In the U.S.
between January 1930 and May 1933 the consumer price index (CPI) fell by
26.3%. This fall in the CPI was accompanied by a sharp decline of 47% in
industrial production between January 1930 and July 1932.</font>
<font size="2"> </font>
<font size="2">Likewise in Japan: the CPI, which stood at 101.63 in
November 98, fell to 98.3 by March 2003 representing a fall of 3.3%. The fall
in the CPI was accompanied by depressed economic activity with industrial
output now well below the long-term trend for a fifth consecutive year.</font>
<font size="2">Based on the view that price deflation is bad news, many
experts suggest that the Fed should adopt a policy of targeting inflation.
According to this logic, while price deflation causes consumers to postpone
buying, which in turn leads to economic depression, price inflation leads to
the exact opposite. Hence by targeting price inflation the central bank could
influence consumer buying and therefore general economic activity. The
remedy for an economic slump brought about by price deflation is inflation, or
so it is held.</font>
<font size="2">But is it true that a fall in price inflation is such bad
news? For example, in the U.S. from 1880 to 1896 wholesale prices fell on
average by 1.8% per annum. Yet during this period we didn't observe a calamity
but on the contrary income was growing at 5% per annum.</font><a title href="http://www.mises.org/fullstory.asp?control=1225#_ftn1" name="_ftnref1"><font size="2">[1]</font></a>
<font size="2">Moreover, if a fall in prices causes people to postpone
their buying, why wasn't this the case with regard to personal computers?
Computer sales between 1992 and February 2003 increased by 127%,
notwithstanding the fact that prices of personal computers fell by 80% during
this period.</font>
<font size="2">Also, between January 1992 and February 2003 the prices of
appliances fell by over 20% while sales of appliances during this period
increased by 129%.</font>
<font size="2">As such, changes in prices do not set in motion economic
conditions but rather changes in prices are the manifestation of economic
conditions. Thus for a given stock of money and an expanding production of
goods and services, i.e. an expansion in real wealth, prices will develop a
declining tendency. Falling prices, then, are the manifestation of the fact
that the holders of dollars can now acquire a greater amount of goods and
services.</font>
<font size="2">According to Murray Rothbard,</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font size="2">Improved standards of living come to the public from the
fruits of capital investment. Increased productivity tends to lower prices
(and costs) and thereby distribute the fruits of free enterprise to all the
public, raising the standard of living of all consumers. Forcible propping
up of the price level prevents this spread of higher living standards.</font><a title href="http://www.mises.org/fullstory.asp?control=1225#_ftn2" name="_ftnref2"><font size="2">[2]</font></a>
[/i]
<font size="2">Prices will also develop a declining tendency on account of
the bursting of the monetary bubble. In other words, once the bubble is burst
this undermines various nonwealth-generating activities that sprang up on the
back of prior monetary pumping. Note however, that this fall in prices is
welcome news because the fall indicates that the diversion of real wealth from
productive activities was arrested. In short, a fall in prices is indicative
that the healing of the economy has begun.</font>
<font size="2">On this Mises wrote,</font>
<blockquote dir="ltr" style="MARGIN-RIGHT: 0px">
<font size="2">As soon as the depression appears, there is a general
lament over deflation and people clamor for a continuation of the
expansionist policy.... Every firm is intent upon increasing its cash
holdings, and these endeavors affect the ratio between the supply of money
(in the broader sense) and the demand for money (in the broader sense) for
cash holding. This may be properly called deflation. But it is a serious
blunder to believe that the fall in commodity prices is caused by this
striving after cash holding. The causation is the other way around. Prices
of the factors of production—both material and human—have reached an
excessive height in the boom period. They must come down before business can
become profitable again. The entrepreneurs enlarge their cash holding
because they abstain from buying goods and hiring workers as long as the
structure of prices and wages is not adjusted to the real state of the
market data. Thus any attempt of the government of the labor unions to
prevent or to delay this adjustment merely prolongs the stagnation.</font><a title href="http://www.mises.org/fullstory.asp?control=1225#_ftn3" name="_ftnref3"><font size="2">[3]</font></a>
[/i]
<font size="2">It follows then that a fall in prices, which is labeled as
price deflation, is always good news.</font>
<font size="2">The Fed may have painted itself into a corner</font>
<font size="2">Despite all the attempts that the Fed is likely to make in
order to inflate the economy there is a possibility that it may fail. Why is
that so? The main reason is that the current aggressive loose monetary policy,
in addition to previous loose monetary policies, may have severely weakened
the pool of real funding—the heart of economic growth. Various indications
raise the likelihood that this pool is in trouble. For instance the
income-to-consumption ratio is in free fall. In fact the fall in this ratio is
currently much steeper than during the Great Depression.</font>
<font size="2">Moreover, despite the aggressive lowering of interest rates
by the Fed industrial production has been below its long-term trend for almost
two years.</font>
<p align="center">
<font size="2">In other words, what we are currently observing in Japan is
that the facts of reality are forcing the central bank to lower its monetary
pumping. </font>
<font size="2">For the time being, U.S. bank lending remains buoyant. The
yearly rate of increase of commercial bank combined consumer, business and
real estate loans jumped to 8% in April from 7.7% in March. However, a further
weakening in economic activity runs the risk that the growth momentum of
lending will follow suit. Moreover, if economic conditions were to deteriorate,
a further loosening in the Fed's interest rate stance is likely to diminish
banks' incentive to lend.</font>
<font size="2">Incidentally, this may already be emerging. The main driving
force behind commercial banks' still buoyant lending is real estate loans. The
yearly rate of increase in these loans climbed to 17.2% in April from 16.7% in
March. However, commercial bank loans excluding real estate lending fell
year-on-year in April by 2.5% after a fall of 2.6% in the previous month. This
was the 19<sup>th</sup> consecutive monthly decline. With the likely
bursting of the real estate bubble we suspect that real estate loans will also
follow suit and overall bank lending will come under pressure.</font>
<font size="2">Some experts are of the view that even if commercial banks
curtail their lending the Fed could still revive monetary pumping and the
economy by employing the"helicopter money" approach, i.e., by
mailing every citizen in the U.S. a given amount of money. The increase in
money not only will boost consumption expenditure but will also weaken the
dollar exchange rate thereby giving a boost to exports, so it is held. It is
also suggested that the Fed could aggressively lower long-term interest rates
in order to boost business expenditure on capital goods.</font>
<font size="2">But any attempt to implement this type of policy will only
result in more distortions and retard the U.S. economy for many years.
Furthermore, before one can consider exporting goods one must produce these
goods. However, how is it at all possible to boost exports while monetary
pumping is diluting the sources of real wealth generation? After all, if
currency depreciation could fix economic growth then by now poverty world-wide
would have been eradicated.</font>
<font size="2">But, the way things currently stand, as far as economic
thinking is concerned, it would not be surprising that if the economy and core
price indices were to weaken further the Fed would continue to loosen its
monetary stance in the months ahead.</font>
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<font size="2">Frank Shostak is an adjunct scholar of the Mises Institute
and a frequent contributor to Mises.org. Send him <font color="#000080" size="2">MAIL</font> and
see his outstanding Mises.org <font color="#3571ca" size="2">Daily
Articles Archive</font>. Special thanks to Michael Ryan for his comments.</font>
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<div id="ftn1">
<a title href="http://www.mises.org/fullstory.asp?control=1225#_ftnref1" name="_ftn1"><font size="2">[1]</font></a><font size="2"> Joseph
Salerno. “</font><font size="2">An
Austrian Taxonomy of Deflation</font><font size="2">” Mises
Institute. Jan 19, 2002).</font>
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<div id="ftn2">
<a title href="http://www.mises.org/fullstory.asp?control=1225#_ftnref2" name="_ftn2"><font size="2">[2]</font></a><font size="2">
Murray N. Rothbard. [1963] 1990."</font><font size="2">What
has Government done to our money</font><font size="2">?" P. 17,
Mises Institute.</font>
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<a title href="http://www.mises.org/fullstory.asp?control=1225#_ftnref3" name="_ftn3"><font size="2">[3]</font></a><font size="2">
Ludwig von Mises. 1966. <em>Human Action</em>, Contemporary Books. 3<sup>rd</sup>
revised edition p 568-9.</font>
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<a title href="http://www.mises.org/fullstory.asp?control=1225#_ftnref4" name="_ftn4"><font size="2">[4]</font></a><font size="2">
Murray N. Rothbard. 2003. A
History of Money and Banking in the United States, Mises
Institute, p. 295.
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