Friday, January 28, 2011

Rothbard Refutes Rothbard on the Effects of Deflation

I have recently seen an article by Philipp Bagus called “Deflation: When Austrians Become Interventionists” (Quarterly Journal of Austrian Economics 6.4 2003: 19–35). One does not have to agree with Bagus’ pro-deflation views to learn from this article.

Bagus points out a contradiction in Rothbard’s thinking on deflation, from the perspective of his own ethics and anti-fractional reserve banking theory.

But there is also another contradiction about the effects of deflation of which Rothbard is guilty. The essence of Rothbard’s views on this subject (at least in many of his writings) is that there is nothing “inherently bad about deflation” (Bagus 2003: 24).

Certainly in Man, Economy, and State (p. 766) there is a clear statement to this effect:
“Similarly, a decrease in the money stock involves no social loss. For money is used only for its purchasing power in exchange, and an increase in the money stock simply dilutes the purchasing power of each monetary unit. Conversely, a fall in the money stock increases the purchasing power of each unit” (Rothbard 2004 [1962]: 766).
Again in America’s Great Depression, Rothbard dismisses the idea of debt deflation, if prices are falling:
“It has often been maintained that a failing price level injures business firms because it aggravates the burden of fixed monetary debt. However, the creditors of a firm are just as much its owners as are the equity shareholders. The equity shareholders have less equity in the business to the extent of its debts. Bond holders (long-term creditors) are just different types of owners, very much as preferred and common stock holders exercise their ownership rights differently. Creditors save money and invest it in an enterprise, just as do stockholders. Therefore, no change in price level by itself helps or hampers a business; creditor-owners and debt-owners” (Rothbard 2000: 51, n. 16).
But then in The Mystery of Banking (originally published in 1983), Rothbard proposed a plan for a return to the gold standard (Rothbard 2008: 261–268), as follows:
“I propose that, in order to separate the government totally from money, its hoard of gold must be denationalized … What better way to denationalize gold than to take every aliquot dollar and redeem it concretely and directly in the form of gold? And since demand deposits are part of the money supply, why not also assure 100% reserve banking at the same time by disgorging the gold at Fort Knox to each individual and bank holder, directly redeeming each aliquot dollar of currency and demand deposits? In short, the new dollar price of gold (or the weight of the dollar), is to be defined so that there will be enough gold dollars to redeem every Federal Reserve note and demand deposit, one for one. And then, the Federal Reserve System is to liquidate itself by disgorging the actual gold in exchange for Federal Reserve notes, and by giving the banks enough gold to have 100% reserve of gold behind their demand deposits. After that point, each bank will have 100% reserve of gold, so that a law holding fractional reserve banking as fraud and enforcing 100% reserve would not entail any deflation or contraction of the money supply. The 100% provision may be enforced by the courts and/or by free banking and the glare of public opinion” (Rothbard 2008: 262–263).
Thus Rothbard wished to avoid a contraction of the money stock, and defended it on these grounds:
“we have the advantage of starting from Point Zero, of letting bygones be bygones, and of insuring against wracking deflation that would lead to a severe recession and numerous bankruptcies. For the logic of returning at $500 would require a deflation of the money supply down to the level of existing bank reserves. This would be a massive deflationary wringer indeed, and one wonders whether a policy, equally sound and free market oriented, which can avoid such a virtual if short-lived economic holocaust might not be a more sensible solution” (Rothbard 2008: 267).
If deflation of the money stock (admittedly the one imagined by Rothbard would be a very severe one) has no serious consequences for output and employment or no social loss (as in Rothbard 2004 [1962]: 766), then why would it lead to “severe recession and numerous bankruptcies,” as stated here? Rothbard has contradicted himself.

As Bagus (2003: 22–23) points out, Rothbard’s plan also seems to contradict his own stated ethics and opposition to fractional reserve banking:
“… Rothbard’s plan … is not only a prevention of justice but it entails an additional injustice, since he proposes to give to the banks gold that is the just property of other people. That is theft. It must be noted that the application of Rothbard’s theory of ethics must bring about deflation by ending all fiduciary media. Strangely enough, Rothbard does not apply his theory of ethics to his plan of monetary reform. In contrast he proposed a plan that contradicts his ethical theory and is—according to it—dead unjust” (Bagus 2003: 23).
Moreover, Bagus provides a review of the opinions of other Austrians on deflation, including Mises, Hans Sennholz, Jesús Huerta de Soto, Hayek, and George Reisman. He finds some negative views on deflation amongst some of these authors, and rightly notes Hayek’s volte face late in life on the issue of “secondary deflation.”

ADDENDUM

It is worth quoting Roger Garrison for another modern Austrian view on deflation.

See R. W. Garrison, “The Austrian School,” in B. Snowdon and H. R. Vane (eds), Modern Macroeconomics: Its Origins, Development and Current State, Edward Elgar, Cheltenham. 2005. p. 515:
“Deflation, like inflation, is a secondary issue in the Austrian literature. Growth-induced deflation, that is, the decline in some overall price index that accompanies increases in real output, is considered a non-problem. Here, the microeconomic forces that govern individual markets are fully in play.

Deflation caused by a severe monetary contraction is another matter. Strong downward pressures on prices in general put undue burdens on market mechanisms. Unless, implausibly, all prices and wages adjust instantaneously to the lower money supply, output levels will fall. Monetary contraction could be the root cause of a downturn - as, for instance, it seems to have been in the 1936–7 episode in the USA. The Federal Reserve, failing to understand the significance of the excess reserves held by commercial banks, dramatically increased reserve requirements, causing the money supply to plummet as banks rebuilt their cushion of free reserves. But what caused the money supply to fall at the end of the 1920s boom? The monetarists attribute the monetary contraction to the inherent ineptness of the central bank or to the central bank’s (ill-conceived) attempt to end the speculative orgy in the stock market, an orgy that itself goes unexplained. In the context of Austrian business cycle theory, the collapse in the money supply is a complicating factor rather than the root cause of the downturn. In 1929, when the economy was in the final throes of a credit-induced boom, the Federal Reserve, uncertain about just what to do and hampered by internal conflict, allowed the money supply to collapse. The negative monetary growth during the period 1929 to 1933 helps to account for the unprecedented depth of the depression. But like Keynes’s focus on the loss of business confidence, the monetarists’ focus on the collapse of the money supply diverts attention from the underlying maladjustments in the economy that preceded – and necessitated – the downturn”.
The crucial factors ignored by Austrians in regard to the 1929–1933 collapse are the unstable nature of poorly regulated financial markets, the deflation of an asset bubble fuelled by excessive debt, and debt deflationary collapse. US monetary policy was no doubt hampered by the gold standard – or perhaps, more accurately, “gold standard thinking” from which policy-makers had difficulties extracting themselves.


BIBLIOGRAPHY

Bagus, P. 2003. “Deflation: When Austrians Become Interventionists,” Quarterly Journal of Austrian Economics 6.4: 19–35.

Garrison, R. W. 2005. “The Austrian School,” in B. Snowdon and H. R. Vane (eds), Modern Macroeconomics: Its Origins, Development and Current State, Edward Elgar, Cheltenham. 474–516.

Mises, L. 1996. Human Action: A Treatise on Economics (4th rev. edn), Fox and Wilkes, San Francisco.

Rothbard, M. N. 2000 [1963]. America’s Great Depression (5th edn), Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Rothbard, M. N. 2008. The Mystery of Banking (2nd edn), Ludwig von Mises Institute, Auburn, Ala.

28 comments:

  1. I don't think it contradicts with his theory of ethics. Rothbard states he wants the gold back for each individual and bank holder:

    "And since demand deposits are part of the money supply, why not also assure 100% reserve banking at the same time by disgorging the gold at Fort Knox to each individual and bank holder, directly redeeming each aliquot dollar of currency and demand deposits?"

    That sounds quite consistent with his ideas.

    What are clearly plain wrong are his statements in Man, Economy and State and America's Great Depression. Maybe the only way to save Rothbard from his inconsistencies is to make a difference between "deflation" (contraction of the money supply or falling price level) and "wracking deflation" (whatever wracking means according to Rothbard we don't know, he never went in detail with this).

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  2. "Maybe the only way to save Rothbard from his inconsistencies is to make a difference between "deflation" (contraction of the money supply or falling price level) and "wracking deflation" (whatever wracking means according to Rothbard we don't know, he never went in detail with this)."

    "Wracking deflation" presumably means very severe deflation. The word "deflation" could refer to very mild, moderate or severe deflation.

    But, if "wracking deflation" is harmful to an economy, then it is obvious that the statement that "a decrease in the money stock involves no social loss" is wrong - Rothbard is inconsistent and contradicts himself.

    It seems to me that some Austrians do in fact recognise that certain types of deflation (though not all) can cause a collapse in output and unemployment through a deflationary spiral.

    It is a pity that this hasn't filtered through to the hordes of "pop" Austrians on the internet.

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  3. Is deflation a non-problem? There are solutions to the "deflation" problem. In a 100% commodity backed money, the solution is to produce more of the backing commodities (mining gold, for example) so that an increase in money (gold certificates) can follow. In a fractional reserve free-banking system, the solution is to create more fiduciary media. In a fractional reserve system with a central bank, again, the solution is to create more fiduciary media. This would soften the coordination problem of the market forces when prices unexpectedly fall.

    A soft and steady deflation is no more of a problem than a soft a steady inflation. I just can't see how the logic could be different in both cases.

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  4. Lord Keynes,
    Thank for the post.

    "The crucial factors ignored by Austrians in regard to the 1929–1933 collapse are the unstable nature of poorly regulated financial markets, the deflation of an asset bubble fuelled by excessive debt, and debt deflationary collapse."

    I repeat : price-wage flexibility will immediately clear the market. Let the government stabilize actual wage rate and unemployment will automatically rise, increasing uncertainty.
    You say : financial markets are naturally unstable. Guess what : if you buy more and more assets, commodity prices will go down, and people readjust their spendings. They buy less assets and more commodities.
    So... why commodity prices don't fall ? Because of money creation (and keynesians).
    I would suggest you read this article :
    http://mises.org/daily/3517

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  5. "I repeat : price-wage flexibility will immediately clear the market."

    In the real world, wages are not flexible.

    This problem of wage "stickiness" is a well known one in modern economics. People in general object to having their nominal wages cut. Even managers often dislike across-the-board pay cuts. Recent studies suggest that employers actually avoid pay cuts because they diminish workers’ morale, and then the falling morale reduces productivity.

    See T. F. Bewley, 1999. Why Wages Don’t Fall During a Recession, Harvard University Press, Cambridge, MA.

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  6. "Let the government stabilize actual wage rate and unemployment will automatically rise, increasing uncertainty."

    You are proposing government intervention to cut wages and make them flexible?

    "Guess what : if you buy more and more assets, commodity prices will go down, and people readjust their spendings."

    People will NOT readjust their spending in an economy hit by a depression, there will be mass unemployment, poverty, and output contraction.


    Financial assets are not gross substitutes for producible commodities

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  7. Lord Keynes,
    People object to having their nominal wages cut ? So, unemployment will rise. Then they cannot maintain these wage rates any longer (but Unions and Minimum Wage can !), because unemployed people force them to accept a lower nominal wage.
    Wages are not "naturally" sticky. And this is why the theory of "efficiency wage" is a fallacy.

    "People will NOT readjust their spending in an economy hit by a depression, there will be mass unemployment, poverty, and output contraction."

    You know what I mean. In normal situation, people don't buy more and more assets. Information cascade, animal spirits, or self-fulfilling prophecy cannot explain bubbles.

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  8. "Wages are not "naturally" sticky."

    A statement blatantly contradicted by the empirical evidence.
    And what do you mean by "naturally"? Do you mean "what generally happens in the real world"?
    If so, then wages are "naturally" sticky.

    And again regarding this comment:

    "if you buy more and more assets, commodity prices will go down, and people readjust their spendings. They buy less assets and more commodities."

    Your error is assuming the "the gross substitution axiom", just like the neoclassicals:

    “The elasticity of substitution between all (nonproducible) liquid assets and the producible goods and services of industry is zero. Any increase in demand for liquidity (that is, a demand for nonproducible liquid financial assets to be held as a store of value), and the resulting changes in relative prices between nonproducible liquid assets and the products of industry will not divert this increase in demand for nonproducible liquid assets into a demand for producible goods and/or services” (Paul Davidson, Financial markets, money, and the real world, p. 44).

    The gross substitution axiom is wrong, and all inferences made from it (like yours) are also wrong.

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  9. Also, I have already discussed this subject on another blog post:

    "Financial assets are not gross substitutes for commodities. The neoclassical gross substitution axiom is wrong. In both a commodity money and fiat money world, savings are held in the form of money and non-producible financial assets. An increase in demand for money and non-producible financial assets and rising prices of such liquid assets will not spill over into a demand for relatively cheaper commodities, because the elasticity of substitution of money and liquid assets is zero or near zero (Davidson 2010: 256–257; Davidson 2002: 44–45; see also Hahn 1977: 31). Even if wages and prices were perfectly flexible, there could still be “leakages” in aggregate supply in the form of speculation on financial asset markets which would be “non-employment inducing demand” (Davidson 2010: 257; Hahn 1977: 37)."

    http://socialdemocracy21stcentury.blogspot.com/2010/10/myth-of-says-law.html

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  10. "Mr Bewley concludes that employers resist pay cuts largely because the savings from lower wages are usually outweighed by the cost of denting workers’ morale: pay cuts hit workers' standard of living and lower their self-esteem. Falling morale raises staff turnover and reduces productivity."

    If entrepreneur A refuse to cut its wages, there are more unemployed. So entrepreneur B can increase the production with the new employees he recruits. In non-union environments, employers will increase or stabilize wages "only" if they are having trouble attracting people (i.e. if there is scarcity of labour supply). Why we should fear deflation ?
    Perhaps Bewley is right. During a depression, the act of lowering wage will depress worker's morale and productivity. Why not. Why not. But in "normal situation" there is no reason to fear deflation, if nominal wage fall because of productivity gains : in "this" situation, the standard of living will go up. (see Guido Hülsmann)

    Lord Keynes,

    You're wrong again in citing Paul Davidson. If people really want more money, more coins to hold, and supposing the gold supply cannot be expanded, why people cannot choose another medium of exchange ? Why they cannot pay with silver ? Or platinum ? Or anything else ?

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  11. "If people really want more money, more coins to hold, and supposing the gold supply cannot be expanded, why people cannot choose another medium of exchange?"

    The answer to your question can be given by history.

    What you describe actually happened in the United States in the late 19th century, as the deflation from 1873-1896 caused a popular movement to demand a increased money stock by free silver:

    "Free Silver was an important United States political policy issue in the late 19th century and early 20th century. Its advocates were in favor of an inflationary monetary policy using the "free coinage of silver"; its supporters were called "Silverites". It largely pitted the financial establishment of the Northeast, who were creditors and would be hurt by inflation, against the more rural areas of the country, who were debtors and would benefit from inflation: farmers in the Midwest, miners in the West, and Southerners still chafing against federal government control.

    The debate lasted from the Coinage Act of 1873, which demonetized silver, to the Federal Reserve Act of 1913, which radically overhauled the US monetary system, coming to a head in the presidential election of 1896, most memorably in the Cross of Gold speech. Throughout, Free Silver was consistently defeated"
    http://en.wikipedia.org/wiki/Free_Silver

    So to answer your question: "why people cannot choose another medium of exchange?"

    In one of the most attempts to use "another medium of exchange" in America, the "free silver" movement was defeated by gold standard fundamentalists - the sort of people, I suspect, who would be cheered on by modern Austrians.

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  12. Correction:

    In one of the most significant and popular attempts to use "another medium of exchange" in America,

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  13. Lord Keynes,
    I don't see the problem you pointed out. Are you trying to refute my argument ?
    I don't know much about "free silver" but there is no reason no one couldn't use and accept another medium in the face of a scarcity of the actual medium (gold, silver...). You seem to admit that there is no choice. No choice whatever they do, no choice whatever they try. You "know" that's not true. There is no choice because of government intervention. Have you ever heard about legal tender laws ? I suggest you read "The Ethics of Money Production" from Guido Hülsmann (chapter 9 and 10).
    Maybe I'm wrong. In that case, prove it. Prove that your conclusion is correct in assuming the fact that no one can choose and use another medium, while people are demanding more money.

    Oh, and about deflation, I'm starting to read Bewley's book. You (and he) said "stickiness" is natural. But there is always economic forces. When you layoff your employees, you are just increasing unemployment rate. Market clearing will force entrepreneurs to readjust their actions because unemployed are scrambling to find jobs. They accept less wages and they will work harder because they refuse to stay unemployed and uninsured, and to die from starvation. They "just" want a job, not a higher wage. So where is productivity losses ?

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  14. "Market clearing will force entrepreneurs to readjust their actions because unemployed are scrambling to find jobs."

    When ecnomonies are struck by severe recessions or depressions, entrepreneurs will NOT engage in sufficient investment because of low or poor expectations

    "They accept less wages and they will work harder because they refuse to stay unemployed and uninsured, and to die from starvation."

    Again you assume wages are flexible and that markets will clear. They won't:

    http://socialdemocracy21stcentury.blogspot.com/2011/01/f-h-hahn-in-candid-moment-on-neo.html

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  15. I re-re-re-repeat : In "normal situation", people don't buy more and more assets. And recession is caused by an excess supply of fiduciary media. Lower interest rates give incentives to inflate bubble, buying more and more assets (because consumption goods prices don't fall) while entrepreneurs expand their productive capacity, thanks to lower interest rates again; after that, bubble will burst. Then, and only after bubble burst, recession comes. And "not" before, whatever you think.

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  16. "People in general object to having their nominal wages cut. Even managers often dislike across-the-board pay cuts. Recent studies suggest that employers actually avoid pay cuts"

    LK, employees always prefer higher wages, even employers often prefer higher wages, provided higher wages reduce staff turnover (that is basically the reason why wages rise at all). However, in a depression, employees are happy and super-productive if they can keep their jobs even after salary decrease. If they are not, the higher unemployment follows, and then they are finally happy, the circle closed. Market clearing is a self correcting mechanism, not only it does not need a benevolent economic tsar (the position you all keynesians aspire to), but it precisely needs the lack of such tsar. In other words, it's like the computer joke, keynesians always try to fix problems they have created in the first place.

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  17. "Market clearing is a self correcting mechanism,

    There is no tendency to full employment equilibrium in free market systems:

    http://socialdemocracy21stcentury.blogspot.com/2011/01/f-h-hahn-in-candid-moment-on-neo.html

    And as to the Austrian idea of plan/pattern co-ordination - the sly Austrian replacement for neoclassical full employment equilibrium - that too is a myth, just as your fellow Austrian Ludwig Lachmann understood:

    “In a kaleidic society the equilibrating forces, operating slowly, especially where much of the capital equipment is durable and specific, are always overtaken by unexpected change before they have done their work, and the results of their operation disrupted before they can bear fruit. Restless asset markets, redistributing wealth every day by engendering capital gains and losses, are just one instance, though in a market economy an important one, of the forces of change thwarting the equilibrating forces. Equilibrium of the economic system as a whole will thus never be reached. Marshallian markets for individual goods may for a time find their respective equilibria. The economic system never does.”
    (L. M. Lachmann, 1976. “From Mises to Shackle: An Essay on Austrian Economics and the Kaleidic Society,” Journal of Economic Literature 14.1: p. 60-1).

    What Lachmann says here is much the same as what Keynes and Post Keynesians say.

    The “plan coordination” imagined by Hayek and other Austrians will not occur under these conditions of uncertainty, subjective expectations and money with a store of value function.

    With no equilibrium (full employment and optimum use of resource) there is a space for government intervention on both moral and economic grounds.

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  18. Lachmann has merely said that "equilibrium of the economic system as a whole will thus never be reached", not that there is "no tendency to full employment equilibrium". The tendency exists precisely because it never reaches what it tends to, basics.

    "With no equilibrium (full employment and optimum use of resource) there is a space for government intervention"

    I know Keynesians would love to achieve such equilibrium because only then their models would finally reflect reality, but that would also mean mean a full stop to all economic and technological progress. Of course in a capitalist reality, keynesians can never achieve the equilibrium, such efforts suffer from precisely same information problems as of socialist central planning.

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  19. "The tendency exists precisely because it never reaches what it tends to, basics."

    This is an oxymoron.

    "I know Keynesians would love to achieve such equilibrium

    What? Full employment equilibrium? Many countries have experenced that under Keynesian systems of demand management since 1945.

    "because only then their models would finally reflect reality, but that would also mean mean a full stop to all economic and technological progress."

    A non sequitur.

    I suspect you probably don't even know what full employemnt is in Keynesian economics.

    A "full employment equilibrium" means an
    equilibrium state where real GDP equals potential GDP, and where unemployment is close to or even below about 3%, and where inflation does not accelerate significantly.

    This means of course that there will be some unemployment - seasonal, frictional etc or where people are changing jobs.

    Keynes thought full employment was when unemployment was about 5%. Post-WWII Keynesians were able to manage economies so well that it went below 3% in many countries.

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  20. "This is an oxymoron."

    For a moment I thought the culprit was I was not a native english speaker, but just checked Merrian Webster and it says tendency is a "direction or approach toward a place, object, effect, or limit", so looks like I'm good, you can't really approach toward a place you've already reached, can you?

    "Post-WWII Keynesians were able to manage economies so well that it went below 3% in many countries."

    And post-WWI socialists were able to manage economies so "well" that the unemployment disappeared completely. Beat this.

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  21. oxymoron = contradiction in terms

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  22. Lord Keynes,
    Joanna makes a lot of good points : "However, in a depression, employees are happy and super-productive if they can keep their jobs even after salary decrease." That's my opinion too. Employees accept less wages and they will work harder because they refuse to stay unemployed and uninsured, relying on unemployment insurance. There would be no loss of productivity.

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  23. If you are already in a depression, then that kind of slump will be necessaily be fixed by people's accepting lower wages.

    In a depression of the 1929-1933 type, there was a massive collapse in aggregate demand due to bank runs, failing banks, loss of people's life savings, collapse of investment and debt deflationary spiral - with a massive fall in business confidence.

    The picture you paint is a riduculous oversimplification of what goes on in severe recessions or depressions.

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  24. Correction:

    "then that kind of slump will NOT necessaily be fixed by people's accepting lower wages."

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  25. "Wage flexibility"... this is what distinguishes the Great Depression from the crisis of 1921 (where a sharp drop in prices led to a rapid and sharp decline in wages, allowing a quick recovery). So why wages don't fall during the GD ? Because Hoover prevented them from falling.

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  26. ""Wage flexibility"... this is what distinguishes the Great Depression from the crisis of 1921"

    You are wrong about 1920-1921:

    "in contrast to the story that gets handed out, there was no comparable decline in wages, according to the one source I could find, the National Industrial Conference Board. Wages rose slightly, and did so again in 1921, the worst year of the recession, when the unemployment rate peaked in July of that year. It is true that finally in 1922, wages fell by 8% before returning to rising in the following year, but the turnaround had come already in late 1921."

    Barkley Rosser, Does The 1920-21 Recession Really Prove That Laissez Faire Saves Us From Recessions?, November 8, 2010

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  27. So Pierre-Cyrille Hautcoeur was wrong ? I'm very sad.
    http://img155.imageshack.us/i/sdc12967d.jpg/
    And what about the recession of 1981 ?
    http://econlog.econlib.org/archives/2010/02/reply_to_delong.html
    (Don't forget to check Tom Dougherty's posts.)

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  28. "unstable nature of poorly regulated financial markets, the deflation of an asset bubble fuelled by excessive debt"
    Although I won't deny this statement, my question is won't a central bank policy of inflating the currency necessarily increase the potential for asset bubbles due to excessive speculation by reducing interest rates and ensuring cheap financing for speculators and their activities?

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