The Fed Is Wrecking the Dollar

by Joseph T. Salerno

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Testimony before the US House of Representatives, Committee on Financial Services, Subcommittee on Monetary Policy, March 17, 2011

The old argument has recently come back into vogue that moderate inflation is desirable to prevent the far greater evil of deflation. What used to be roundly condemned as "creeping inflation" in the 1950s by Fed officials and mainstream economists alike is today given the scientific-sounding name "inflation-targeting" and hailed as the proper goal of monetary policy.¹ In the past decade, this view has been promoted by many mainstream economists, most notably former Fed Chairman Greenspan and current Fed chairman Bernanke. But this view is based on a fundamental confusion. It conflates deflation and depression, which are two very different phenomena. Falling prices are, under most circumstances, absolutely benign and the natural outcome of a prosperous and growing economy. The fear of falling prices is thus a phobia – I call it a "deflation-phobia" – which has no rational basis in economic theory or history.

Let me explain. As technology advances and saving increases in a progressing economy, entrepreneurs and business firms are given the means and the incentive to invest in new methods of production, which in turn enables them to lower their costs and expand their profit margins. For a given good, the natural result is an increase in the supply of the good and more intense competition among its suppliers. Assuming no change in the money supply and continuing technological innovation, this competitive process will drive the unit production costs and price of the good ever downward. Consumers will benefit from the falling price because their real wages will continually increase as each dollar of income commands an increasing quantity of the good in exchange.

This is not merely abstract theoretical speculation; it is precisely the process that occurred in the past four decades with respect to the products of the consumer electronics and high-tech industries. Thus, for example, a mainframe computer sold for $4.7 million in 1970, while today one can purchase a PC that is 20 times faster for less than $1,000. The first hand calculator was introduced in 1971 and was priced at $240 (which is roughly $1,400 in terms of today’s inflated dollar). By 1980, similar hand calculators were selling for $10 despite the fact that the 1970s was the most inflationary peacetime decade in U.S. history. The first HDTV was introduced in 1990 and sold for $36,000. When HDTVs began to be sold widely in the United States in 2003 their prices ranged between $3,000 and $5,000. Today you can purchase one of much higher quality for as little as $500. In the medical field, the price of Lasik eye surgery dropped from $4,000 per eye in 1998, when it was first approved by the FDA, to as little as $300 per eye today.

Now, no one – not even a Keynesian economist – would claim that the spectacular price deflation in these industries has been a bad thing for the U.S. economy. Indeed the falling prices reflect a greater abundance of goods which enhances the welfare of American consumers. Nor has price deflation in these industries diminished profits, production, and employment. In fact, the growth of these industries has been just as spectacular as the decline in the prices of their products. But if deflation is a benign development for both consumers and businesses in individual markets and industries then why should we fear a fall in the general price level, which of course is nothing but an average of the prices of individual goods? The answer given by theory and history is that a falling price level is the natural outcome of a dynamic market economy operating with a sound money like gold.

Under a gold standard, prices naturally tend to decline as ongoing technological advance and investment in more and better capital goods rapidly improve labor productivity and increase the supplies of consumer goods, while the money supply grows very gradually. For instance, throughout the nineteenth century and up until World War I, the heyday of the classical gold standard, a mild deflationary trend prevailed in the U.S. As a result, an American consumer in the year 1913 needed only $0.79 to purchase the same basket of goods that required $1.00 to purchase in 1800. In other words, due to the gentle fall in prices during the nineteenth century, a dollar purchased 27 percent more in terms of goods in 1913 than it did in 1800. Contrast this with the current day consumer who must pay over $22 for what a consumer in 1913 (the year before the Fed began operating) paid $1.00 for.

Contrary to our contemporary deflation-phobes, the secular fall in prices under the classical gold standard did not impede economic growth in the U.S. In fact, deflation coincided with the spectacular transformation of the United States from an agrarian economy in 1800 to the greatest industrial power on earth by the eve of World War One. If we examine the data more closely, we find that the years from 1880 to 1896 included the decade of the most rapid growth in U.S. history. Yet, during this period, prices fell by almost 30 percent, or by 1.75 percent per year, while real income rose by about 85 percent, or roughly 5 percent per year. More generally, a 2004 study of 73 episodes of deflation from sixteen different countries dating back to 1820 indicates that only 8 of the 73 episodes of deflation involved recession or depression. It also indicates that 21 of the 29 depression episodes involved no deflation. The authors of this study, Andrew Atkeson and Patrick J. Kehoe conclude, "In a broader historical context, beyond the Great Depression, the notion that deflation and depression are linked virtually disappears."  Even when the Great Depression is included in the data, they find that the link between falling prices and negative economic growth is economically insignificant.²

Ironically, while Chairman Bernanke just affirmed again a few days ago that the Fed will persist in its inflationary policy of quantitative easing to ward off the imaginary threat of falling prices, signs of inflation abound. The prices of consumer food staples have risen by 6 percent over the past year, with the prices of beef, bacon, butter and lamb rising by 10 percent or more. The U.N. index of grain export prices has risen by 70 percent in the past year and stands at its highest level in 21 years. Gasoline prices have surged 49 percent in the last six months. According to IMF statistics, commodity prices are up by 33 percent in the past year; metals prices by 40 percent; energy prices by 30 percent; crude oil prices by 31 percent; and commodity industrial inputs by 40 percent.³ As a result of skyrocketing prices of agricultural products such as corn, wheat, soybeans and other crops, the price of farmland in the U.S. has been soaring, particularly in the Midwest where land prices increased at double-digit rates last year and even regulators fear that a bubble is forming.

Just today, USA Today reported "that signs throughout Silicon Valley are starting to show eerie similarities to the dot-com bust."⁴ Facebook is estimated to be worth $75 billion based on private trading from the SharesPost market, which would mean that it is more valuable than Disney. It is rumored to be in a bidding war with Google for Twitter, with the firms considering bids as high as $10 billion. Over the last year, there have been 48 tech IPOs, which is 28 percent of the total number of deals. Also the stock prices of tech IPOs have leaped 19 percent on the first day of trading.

Not only does Chairman Bernanke seem unfazed by these inflationary developments, but, what is more astounding, he appears to welcome the rapid increase in stock prices as evidence that QE2 is working to right the economy. When it became apparent that the Fed’s $600 billion buying program for treasury bonds had failed to reduce long-term interest rates as intended but caused them to rise instead, Mr. Bernanke desperately sought another sign that QE2 was working. While he denied that the Fed was responsible for rapidly rising commodity prices, he credited the Fed with re-igniting the stock market boom. Oddly, he seized on the Russell 2000 index of small cap stocks, which has increased 25 percent in the last six months, stating "A stronger economy helps smaller businesses." In other words, despite the stagnant job creation and sluggish growth of real output, Mr. Bernanke has declared Fed policy a success on the basis of yet another financial asset bubble that threatens again to devastate the global economy. This would be farcical were it not so tragic. But what else can be expected from the leader of an institution whose very rationale is to manipulate interest rates and print money.

1. Time Magazine Editorial, "Creeping Inflation: How to Keep It from Galloping, (Oct. 07, 1957).
2. Andrew Atkeson and Patrick J. Kehoe, "Deflation and Depression: Is There an Empirical Link," American Economic Review Papers and Proceedings 94 (May 2004): 99–103.
3. Commodity data is from Index Mundi.
4. Jon Swartz and Matt Krantz, Is a New Tech Bubble Starting to Grow, USA Today (March 17, 2011).

March 21, 2011

Joseph Salerno [send him mail] is academic vice president of the Mises Institute, chairman of the graduate program in economics at Pace University, and editor of the Quarterly Journal of Austrian Economics.