Endogenous Money, Savings and Inflation

There is a peculiar, ridiculous question parroted by internet Austrians I have noticed of late: “why is it alright to destroy savings via Keynesian policies?,” they cry. By this, they presumably mean that central bank creation of reserves and Keynesian stimulus produce price inflation.

But the question in fact reveals deep ignorance of the basic nature of capitalism.

The endogenous expansion of the money supply is an internal and normal aspect of modern capitalism: it happens by free, non-fraudulent, voluntary processes, such as creation of bills of exchange, promissory notes and fractional reserve banking (FRB). The first two are mostly significant in historical terms today, and FRB is the major source of endogenous money.

The endogenous money system confers benefits: it meets demand for credit for trade, commerce and investment. A consequence of the process is that it often produces price inflation when booms occur (that is, strong expansions in the business cycle). Even in the 19th-century, gold-standard era, booms were basically inflationary (outside of the historically aberrant 1873–1896 period). For example, the US had price inflation under the gold standard in the following booms: 1811–1814, 1825, 1834–1837, 1844–1847, 1841, 1852–1855, 1857, 1859, 1880, and 1896–1914. In particular, there was a period of protracted price inflation in most Western nations from 1896–1914. And note that the United States had no central bank for most of this period.

Modern central bank endogenous monetary systems merely continue what was already a fundamental feature of earlier capitalism, but provide a degree of monetary stability that many previous FR systems lacked. The consequences of prohibiting FRB would be blatant violation of private free contract. The Austrian claims that FRB is fraudulent or immoral are simply nonsense.

The alternative system favoured by some Rothbardians – a system of perpetual deflation – would impose a “tax” on producers and businesses that take on debt to expand output and increase employment: the deflation tax would penalise productive businesses and individuals who must pay back their debts with money of higher purchasing power. The economy would also experience debt deflationary effects.

There would also be powerful disincentives to capital goods investment. By holding money idle, savers would have a guaranteed return. The relentless deflation would also, after some years (say, a 100 years or so) see an astonishingly unequal and high disparity of wealth, if the original society had significant wealth inequality.

As for properly-designed Keynesian stimulus policies, they too confer benefits that outweigh the costs of price inflation. First, price inflation is mostly a secondary effect of stimulus during deep depressions or severe recessions, when idle resources, unused capital goods and unemployment exist. The primary effects of stimulus in the latter circumstances are increases in output and employment. Secondly, the creation of greater employment and output drives real GNP to hit its potential. This makes the community richer than it would otherwise have been, if real GNP had fallen below its potential, and provides a greater level of income owing to higher levels of employment.

UPDATE

Jonathan Finegold Catalán responds to my post above here:

Jonathan Finegold Catalán, “Perpetual Deflation,” Economic Thought,24 February, 2012.

There are a number of things to say in response:

(1) Catalán states

“There are two types of deflation that free bankers like to talk about: secular and monetary. The first they consider benign, and it results from output increasing at rates faster than the supply of money.”

Yet his statement that there is “no theoretical basis for [sc. a deflation tax on debtors], and ... no empirical basis for this” is an assertion without evidence.

Why wouldn’t secular and monetary deflation force debtors to pay back money in higher purchasing power terms, effectively making the burden of their debts higher? Catalán has not, in any way, demonstrated why this would not happen.

(2) Catalán states:

“none of the problems that LK describes came up [sc. in 1873–1896]. In fact, this period was amongst the most productive in the history of the United States (if not the most productive).”

I disagree:

(i) there was a great deal of business pessimism in this period, negatively affecting business expectations. If one bothers to look at contemporary accounts in the business press in both Europe and America, one finds numerous complaints of reduced profits and pessimism. Unless one thinks that shocked expectations do not affect the level of investment, then there is a clear case that investment levels fell below what they could have been.

(ii) there were clear debt deflationary effects in this period. Above all, farmers were pressing for relief from debt deflation. The burden of their debts rose. This was not simply caused by industrialization of agriculture, nor by the fall in the size of agricultural employment in the labour force.

(iii) in this period, the deflation from 1873–1896 caused a popular movement to demand a increased money stock by free silver, often backed by debtors.

(3) Catalán remarks:

“as I note in the review [of Higg’s work on 1873–1896], during this period, moneylenders actually allowed for a dynamic interest rate, which would let the rate on loans fall with prices.”

Yet there were clearly considerable numbers who did not. Otherwise there would not have been significant complains about the burden of debt. Unless you were to legislate to make bankers take account of deflation in contracts, there would not be an evasion of debt deflationary effects.