Money, Sound and Unsound by Joseph T. Salerno

Author:Joseph T. Salerno [Salerno, Joseph T.]
Language: eng
Format: epub, pdf
ISBN: 978-1-933550-93-0
Publisher: Ludwig von Mises Institute
Published: 2010-11-06T16:00:00+00:00

Deflation Fallacies

While blithely ignoring coercive political expropriation of the public’s bank deposits, deflation-phobes exhibit an obsessive and misplaced concern with voluntary, market-driven deflation. Although deflation-phobia ranges across the spectrum of current schools of macroeconomic thought, the most numerous and vociferous group of contemporary deflation-phobes consists of the financial journalists, economic consultants, market pundits and conservative think-tank policy wonks who are more or less closely linked with supply-side economics. Donald L. Luskin, Bruce Bartlett, Richard Rahn, and Larry Kudlow are some of the supply-siders who have weighed in with antideflationist articles. The supply-side anti-deflation program can be boiled down to three basic propositions, each of which rests on fallacious assumptions.

The first proposition is that the prices of gold and other raw commodities are extremely sensitive to changes in monetary conditions and are therefore they are good predictors of future movements of general consumer goods’ prices, which tend to respond much more slowly to such changes. As Bruce Bartlett52 wrote, “When one sees a sustained fall in sensitive commodity prices—those that lead changes in the general price level—one can predict that eventually this trend will work its way through the economy as a whole.” According to Rahn,53 since all major commodity indexes had fallen by double-digit percentages during 2001 and many commodity prices had fallen well below their levels of 10 years earlier, a deflation, possibly as severe as Japan’s, loomed. The declines in CPI and PPI indexes in the fourth quarter of 2001 supposedly represented the first whiff of this onrushing deflation.

The fallacious assumption underlying this proposition is that there always exists a positive relationship between movements in raw commodity prices and movements in consumer prices. However, as the Austrian theory of the business cycle teaches, consumer goods’ prices and capital goods’, including raw commodity, prices change relative to one another during the different phases of the cycle and may very well vary in absolutely opposite directions during a recession.

Since World War II recessions have generally been precipitated by the Fed reducing the rate of growth of bank reserves and hence of the money supply, rather than absolutely contracting bank reserves and money. All other things equal, the immediate result is a reduction in the creation of bank credit, which leads directly to a higher interest rate that discourages business borrowing for investment projects. The subsequent constriction of investment spending causes the prices of capital goods to begin to fall both absolutely and relative to consumer goods’ prices. The latter are generally still increasing at the start of a recession under the pressure exerted by past injections of new money that reaches consumers only after it has been spent by business investors. As profits in the capital goods industries turn negative and profit prospects for planned and partly finished investment projects in these industries suddenly dim, the demand for raw industrial commodities and other inputs specific to the production of capital goods declines precipitously and their prices plunge even further. Shaky capital goods’ firms also scramble to acquire cash and stave

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