We who are advocates of sound, free-market money need to get our story straight. Are we predicting hyperinflation or massive deflation? Personally, I am much more worried about the former problem. Using a recent article by Mish, I hope to show that no one has made a convincing case for falling prices.
Mish’s Argument for Deflation
"Mish" is a very popular blogger on financial and economic affairs. His nickname is a melding of the first two letters of his two real names, Mike Shedlock. (My own friends called me "Romu" for a brief spell, but it didn’t catch on.) For some time Mish has been criticizing those warning about impending inflation, and in a recent post he summed up his position quite well.
Mish was responding to Gary North, who had written, "The Federal Reserve can re-ignite monetary inflation at any time by charging banks a fee to keep excess reserves with the FED."
Mish took issue with North’s claim:
Gary’s hypothesis … is just that, a hypothesis, and I believe a very poor one at that.
Bernanke’s idea to pay interest on reserves will slowly recapitalize banks over time. This is why he desperately wanted to do so. To suggest he is about to charge interest on deposits is silly.
The key fact now is there are not enough credit worthy customers for banks to want to lend, or for that matter willing borrowers looking to expand debt. Thus, if banks had to pay interest on reserves, rather than causing mass inflation, the Fed would cause mass panic.
I humbly submit that we have no idea what Bernanke is going to do next. Well, okay, we have some idea; Bernanke obviously isn’t going to call for the abolition of the Fed. But beyond that, it’s anybody’s guess. There are many economists who think Bernanke’s decision to start paying interest on reserves was a horrible blunder. In any event, Mish is simply assuming that the Fed officials don’t want to "cause mass panic," when an open-minded reading of history makes me wonder.
Let’s not get bogged down on the issue of Fed payment of interest. Here is the crux of Mish’s approach to inflation:
[Some] inflationists look at consumers prices, some look at commodity prices, still others look at the price of gold as a measure of inflation. Of those watching money supply, some concentrate on Base Money supply as Gary North does, others M2, M3, MZM, or even Austrian Money Supply as a measure of inflation…
Every one of them is wrong.
We have a credit based economy and anyone watching money supply and not watching credit is simply wrong. This is a statement of fact, not idle conjecture. Only those watching and expecting the collapse in credit and understanding the role of gold got things correct. This is a very small group of people.
Is Credit Part of the Money Supply?
Although every writer has his or her own nuances, I think it’s safe to generalize and say that the people calling for a "debt deflation" are assuming that the availability of credit acts as "virtual money," and causes prices to be higher than they otherwise would be. Some writers in this camp seem to think that we should just lump someone’s credit line in with his bank balance and currency on hand, in order to come up with how much "purchasing power" he has at his command.
Strictly speaking, that isn’t correct. For simplicity, picture an economy that has no credit system, and where physical gold serves as the commodity money. We start out in an initial equilibrium where the public collectively holds, say, 100 million ounces of gold as cash holdings. Prices of goods and services are quoted in weights of gold, and this vector of prices determines the "purchasing power" of an ounce of gold. Because we’re in equilibrium, everyone is happy holding his portion of the 100 million ounces.
Now suppose in this scenario, a budding entrepreneur gets the bright idea to form Rothbard Express, the first-ever credit card company. That is, Rothbard hands out plastic cards with his logo on them, and merchants agree to accept payment with use of such a card, rather than with actual gold coins. What will be the effect on prices?
At first blush, it seems as if the new business will push up prices. After all, people can now chase goods with not only 100 million ounces of gold, but also with the sum total of their credit lines as extended by Rothbard. In the new equilibrium, wouldn’t prices be higher because of the extra spending?
Bob Murphy [send him mail], adjunct scholar of the Mises Institute, is the author of The Politically Incorrect Guide to Capitalism, The Human Action Study Guide, and The Man, Economy, and State Study Guide. His latest book is The Politically Incorrect Guide to the Great Depression and the New Deal.