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.