Leithner Letter No. 68
August 26, 2005

... It was my belief, and I thought it was shared by all others in the Federal Reserve System, that our whole policy in the future, as in the past, would be directed towards the stability of prices so far as it was possible for us to influence prices.

Benjamin Strong
Private Correspondence (1925)

Looking back ... the great American “stabilisation” of 1922-1929 was really a vast attempt to destabilise the value of money in terms of human effort by means of a colossal programme of investment ... which succeeded for a surprisingly long period, but which no human ingenuity could have managed to direct indefinitely on sound and balanced lines.

D.H. Robertson
“How Do We Want Gold to Behave?” (1932)

In the area of the business cycle, it should be evident to everyone by this time, the Administration, trying subtly and carefully to “fine-tune” us out of inflation without causing a recession, has done just the opposite; bringing us a sharp nationwide recession without having any appreciable impact upon the price inflation. A continuing inflationary recession – combining the worst of both worlds of depression and inflation – is the great contribution of Nixon-Burns-Friedman to the American scene.

Murray Rothbard
Nixonian Socialism (1971)

History cautions that long periods of relative stability often engender unrealistic expectations [about] its permanence and, at times, may lead to financial excess and economic stress. Such perceptions, many observers believe, are contributing to the boom in home prices and creating some associated risks.

Alan Greenspan
Semiannual Monetary Policy Report to the US Congress (2005)

The Scourge of “Low Inflation” in Australia

“The more I ponder the inflation story,” said Stephen Roach on 21 July in No Bottlenecks Without a Bottle, “the more I become convinced that we need to come up with a new approach.” This is because, among other reasons (some of which were canvassed in Inflation Phobia on 15 July), “inflation appears to be down and out, but there are lingering fears of a comeback.” In Roach’s estimation, “these fears are overblown. If anything, the risks are skewed more towards another deflation scare rather than a worldwide acceleration of inflation. Financial markets are not aligned with those risks” (see also Roach’s Inflation Convergence).

As in 2001-2003, so it is today: two words, inflation and inflation, are in many thoughts and on many lips. The trouble is that several years ago the debate about these things generated more heat than light, and the same seems to be occurring today. I applaud Mr Roach’s view that new (which is usually old and long forgotten) thinking should be brought to bear on analyses of inflation and deflation. Such thinking leads me to three conclusions that differ sharply from his:

  1. Inflation has not been vanquished. Quite the contrary: it remains alive and well. If so, then during the next several years inflation and its eventual consequences will be more likely than deflation.

  2. More specifically, the inflation of the past decade may in the next several years cause more rapidly rising wholesale and consumer prices and wages, higher interest rates and a recession – in short, something that in the 1970s was called “stagflation” (see also Letters 21, 41 and 5).

Leithner & Co.’s investment plan has been formulated in order to navigate these hazardous shoals, should they materialise, but it does not predict them. I remain acutely aware that market participants simply cannot foresee such things with any reasonable or profitable degree of accuracy. For that reason, and as always, this plan includes a hefty Grahamite margin of safety.

The lesson for investors is that inflation – that is, aggressive expansions of credit not backed by savings – invariably sets in train a cycle of boom and bust. It does so even when other tendencies temporarily attenuate and obscure the eventual consequences of inflation. Confusions about inflation (and deflation), in other words, lead virtually everybody – including prominent politicians – to flatter themselves and declare that all is well because the overall level of prices is rising at a modest (by the standards of the 1970s) rate. Given justifiable conceptions of inflation and deflation, however, it becomes evident that in a high-inflation environment the price level can rise slowly because other forces – most notably an increase in the supply of goods and services and a rise in the demand for money – offset inflation’s upward pressure upon prices. But these offsetting factors do not repeal the boom-bust cycle. Clearly, then, it is not just primitive and muddle-headed – it is bloody dangerous – to define inflation as a general rise of prices and deflation as a decline in the price level.

It’s Important to Clarify Terms

Inflation and Deflation

The thought experiments in Letter 67, which adhered closely to the premises and reasoning of Murray Rothbard, adopted specie (that is, either gold or silver) as money. In a civilised world, a unit of money is simply a certain weight of specie. For example, the actions of individuals in the market might over the years lead to the rule that a dollar is (say) one ounce of gold. If gold is money, then the supply of money increases when gold and silver are mined, and decreases when these metals are consumed in industrial processes (and, usually much less significantly, when gold and silver coins are subjected to normal wear and tear). Clearly, under these monetary arrangements the supply of money can increase. It did in the 19th century, for example, after massive deposits of gold and silver were mined in Australia, North America and South Africa. Equally clearly, however, extracting ore and refining it into relatively pure gold and silver is hardly costless. It is far more costly than creating money out of thin air.

That is why, as illustrated in Letter 67, monetary intervention typically takes another form: the issue of fake warehouse receipts serving as money-substitutes. Honest banking permits demand deposits and paper notes; but under a non-fractional monetary system their dollar amount will not exceed the corresponding weight of specie deposited. When backed by specie deposited by savers, demand liabilities are genuine warehouse receipts that circulate legitimately as money-substitutes in the market. Pseudo warehouse receipts, on the other hand, are receipts issued in amounts above and beyond the actual specie on deposit. Letter 67 showed that the issue of these receipts is very lucrative. Indistinguishable from the genuine article, these bogus receipts also circulate as money-substitutes. They are fraudulent because the banks’ promise to redeem them in specie at face value cannot possibly be met if all depositors simultaneously request their specie.

Whether or not specie provides the basis of money, commercial banks or governments’ central banks, or the two acting in concert, may undertake monetary intervention. Inflation is the issue of pseudo money receipts (or, more exactly, money-substitutes in amounts that exceed banks’ reserves). And deflation is a contraction of the money supply, aside from a possible decrease in specie. Clearly, no deflation can occur without some previous occurrence of inflation; and the magnitude of any deflation cannot exceed the amount of the earlier inflation. Further, almost every monetary intervention will take the form of inflation. This is because inflation is a well-nigh irresistible temptation to banks and early recipients of the resultant funny-money. They profit from inflation; and what is more, their profit is practically costless. To earn their keep, everybody else must produce and sell goods and services (including gold and silver). To do these things, in turn, they must expend effort and take risks. But the government and commercial banks, it seems, are exempt from such trifles. They can and do create counterfeit money out of thin air. They do not produce it: they simply conjure it.

Inflation, then, is any increase in the supply of money that is not matched by an increase in banks’ reserves; and the specific method of inflation described and analysed in Letter 67 is called credit expansion – that is, the creation of new money-substitutes that enter the structure of production through credit markets. It is vital to distinguish this credit (which is a direct consequence of inflation) from something that is neither a cause nor a consequence of inflation, namely the lending of saved funds.

Individual Prices, The Overall Price Level and the Purchasing Power of Money

Overall prices (that is, the general price level) are determined by the same forces of supply and demand that determine the prices of individual products. (That’s right: pretty much everything through which you suffered in a standard macroeconomics subject, which is a Mad Hatter’s Party with little or no direct linkage to the actions of individuals, is collectivist nonsense.) If the price of bread is $0.50 per loaf, then the purchasing power of a loaf is $0.50 and the purchasing power of $1 is 2 loaves. The price of a particular good or service and the purchasing power of one unit of a product are thus identical. In practice, we cannot add loaves of bread to PCs, motor cars and the countless other goods and services traded in the market; clearly, however, in the abstract the price (or purchasing power) of $1 is the inverse of whatever we can conceive as the price level (or overall level of prices).

To see this, consider a highly simplified example. Suppose that there are two commodities produced in a society and that their prices are eggs = $0.50 per dozen and butter = $1 per kilo. In this society, the purchasing power of the dollar is the two-fold array of alternatives, i.e., either 2 dozen eggs or 1 kilo of butter. Notice that each of the array’s items is the inverse of the individual good’s price. Suppose that the price level doubles in the sense that the prices of each good increases two-fold. Prices then become eggs = $1 per dozen and butter = $2 per kilo. If the price level doubles, the purchasing power of money falls by one-half, i.e., $1 now buys either 1 dozen eggs or 0.5 kilos of butter.

It is important to emphasise two things about the overall level of prices and the price index that purports to measure it. First, the index is a central indicator for economic and monetary policymakers. It directly affects the magnitude of dole payments and indirectly influences the estimation of economic growth and productivity. The percentage change of the index (which the mainstream mistakes as the “inflation rate”) is both a cause and consequence of monetary intervention; and for market participants it helps to establish the yields of bonds and stocks. Second, because the overall level of prices is difficult to conceive the resultant price index it is crude at best and deceptive at worst. Taken naïvely at its face value, as it usually is, it warps the perceptions and distorts the decisions of policymakers, professional and private investors (see, for example, James Grant’s, America’s Hedonism Leaves Germany Cold and Anthony Mueller’s The Illusions of Hedonics).

The Demand for Money

Surely the demand for money is unlimited? Will any individual not accept as much money as anybody is prepared to offer him? The demand for money refers not to how much money people are prepared to accept as a gift, which is indeed unlimited, but to the amount they require in order to finance their everyday expenditures (plus, perhaps, a cash reserve as insurance against unanticipated or emergency expenditures). In this sense, an individual’s demand for money is hardly unlimited. Given Say’s Law, the individual’s demand for money is constrained by his ability to supply goods and services.

The higher the overall level of prices, the lower is the purchasing power of a unit of money and thus the greater the demand for money. Assume, for example, that the overall level of prices suddenly drops by one-half. If so, then people would require much less cash in their wallets and bank accounts to finance their daily expenditures and reserves. People might require only half the cash they presently require; the rest they can either spend or invest. On the other hand, if all prices suddenly doubled then people might demand twice as much money to finance their everyday purchases and hedge against emergencies. When the purchasing power of money is high (that is, prices are low) individuals’ demand for cash balances is low; and when PPM is low (i.e., prices are high) their demand for cash balances is great.

Absent monetary interventionism (that is, given a stable supply of money), the demand for money will over time tend towards an equilibrium vis-à-vis the supply of money. That is, cash balances will correspond to the amounts required to finance daily expenditures and provisions for rainy days; and this equilibrium will determine the purchasing power of money. If, for example, the supply of cash balances exceeds the demand for money, then individuals (considered as a group) hold surplus (with respect to their daily transaction requirements) cash. People eventually discover that their cash balances are greater than required, and so they start to reduce their balances by spending the excess on various goods and services. Given the stable supply of money, some individuals can reduce their balances; but people as a whole cannot. As people spend more money, they place upward pressure upon the prices of goods and services. As overall prices rise, the purchasing power of money falls; as the PPM falls, more cash is required to finance everyday expenditures; and as this cash requirement increases, the surplus of cash balances gradually disappears. Through this market-based process, individuals bring their demand for money into equilibrium with the supply of money.

Why Does the Price Level Change?

Of all people, economists should know better than to define inflation and deflation in terms of changes (positive for inflation, negative for deflation) in the general level of prices. Elementary economics tells us that this is a very unsatisfactory definition. Prices respond to many different causal factors. For our purposes, three are most important:

  1. Prices may change because the supply of goods on the market changes. All else equal, an increase in the supply of goods places downward pressure upon the overall level of prices.

  2. Prices may change in response to a change in the demand for money. Other things equal, an increase in the demand for money places downward pressure upon the overall level of prices.

  3. Prices may rise or fall as a result of a change in the supply of money. All else equal, an increase in the supply of money places upward pressure upon the overall level of prices.

To lump all these causes together obfuscates these separate influences upon the overall price level, and thus risks drawing misleading inferences. For example, (i) the central and commercial banks may be (as they almost always are) increasing the supply of money whilst at the same time (ii) the demand for money and (iii) the overall supply of goods and services are increasing. The second and third factors may largely offset the first, such that little or no increase of overall prices occurs. Yet each of these three processes has distinct economic consequences. Perhaps most notably, as a result of inflation resources will be redistributed and investments misallocated, and the business cycle caused by credit expansion will appear.

Let us assume a stable supply of goods and demand for money and see what happens to the overall level of prices when the supply of money increases. Assume that banks increase the supply of fake warehouse receipts that circulate as money. This means that the aggregate total of cash balances in the economy increases. People now have surplus (relative to the old price level) cash balances to finance their daily expenditures. They therefore spend this excess; and as more money chases the same quantity of goods, they place upward pressure upon the prices of goods. As these prices rise, people find that more cash is required to finance their purchases and therefore that cash balances are becoming less and less excessive. The overall level of prices rises until people’s unchanged demand for money corresponds to the new (increased) supply of money.

Let us now assume a stable supply of goods and money and see what happens to the overall level of prices when the demand for money increases. Let us say, for example, that people considered as a whole become more cautious and thereby desire to hold a greater amount of cash as a provision against misfortune and emergency. This means that, whatever the price level, the amount of money that people wish to hold as cash balances (including bank deposits) increases. The immediate result is that the demand for money exceeds its fixed supply. There is now an excess demand for money (or, stated in other words, a shortage of cash balances) at the old price level. A scramble to accumulate larger cash balances begins, and people will spend less and save more in order to retain the cash they desire. Given the stable supply of money, the aggregate or total supply of cash balances cannot increase. But the fall of prices that results from the decreased spending will alleviate the shortage. Prices thus fall and the purchasing power of money rises. Given the increased PPM, the fixed supply of money is now sufficient to satisfy the greater demand for cash balances. Total cash balances, in other words, have remained the same in nominal terms; but in real terms (i.e., in terms of money’s increased purchasing power) cash balances are now worth more. Here, too, the market clears and the supply of and demand for money return to equilibrium.

How does an increase in the supply of goods affect the overall level of prices? Recall that, following Say’s Law (see Letter 64), before an individual can hold money he must sell something in exchange for money. That is, in order to “buy” more money the individual must sell more goods. As a result, if the supply of goods increases, so too will the demand for money. An increased demand for money generates a shortage of cash balances at the old price level. This shortage increases the purchasing power of money and thereby decreases the overall level of prices. In response to the increased supply of goods, the price level falls until the shortage of cash balances disappears.

With these points in mind, reflect upon a very important historical fact: year after year and with few exceptions (typically, periods of war), the supply of goods and services has tended to increase. The resultant increase in the demand for money has placed downward pressure upon the overall level of prices. And note another crucial fact: except during periods of war, from the middle of the 18th until the middle of the 20th century, the price level in Anglo-American countries tended to fall. Yes, the issue of fake warehouse receipts increased during this long period; but it seems that the increased supply of money was more than offset by some combination of increased supply of goods and heightened demand for money. Accordingly, during this long period the simultaneous occurrence of modest inflation and gently falling consumer prices was the norm. This historical norm has for years seemed to dumbfound mainstream minds because, among this majority, the study of economic history has for years been abnormal.

Expectations About the Price Level

Perhaps the most important influence upon the demand for money – and thus an important influence upon the overall level of prices – are the expectations held by members of the public about the overall level of prices in the short-term (next year), medium-term (next five years) and long-term (five years and beyond). These expectations, it is reasonable to suppose, are not arbitrary. Instead, they are influenced most directly by the change in the price level during the past year, less directly by the change during the previous five years and least directly by the change during the more distant past. The longer and more consistently something has occurred, in other words, the stronger is people’s tendency to expect it to continue into the future. The longer the period of time during which overall prices have risen slowly, for example, the stronger the public’s expectation that prices will continue to rise slowly.

If prices are generally expected to remain stable, then the demand for money – or, at any rate, the influence of expectations upon this demand – will also remain stable. But suppose that, as occurred during the relatively free-market and hard money 19th century, prices fall gradually from year to year. If the historical record leads people to expect that prices will fall by (say) 1% during the following year, they will have a slightly greater incentive to save their money, postpone purchases and buy in the future when each of their dollars will command somewhat more goods and services. By their very nature, daily expenditures cannot be postponed; equally clearly, however, purchases of durable consumer goods (white goods, cars, houses, etc.) can be delayed. Given these expectations (which today’s mainstream calls “deflationary expectations”), the demand for money will rise and the general level of prices will fall. Participants in markets, expecting prices to fall, anticipate and discount this fall, and thereby encourage it to happen sooner rather than later.

If, on the other hand, people anticipate that the overall level of prices will rise in the future, they will tend to buy now rather later (when prices will be higher and the purchasing power of their money lower). In response to these expectations (which today’s mainstream has dubbed “inflationary expectations”), people will attempt to reduce their cash balances. Their lower demand for cash places upward pressure upon prices. The more people anticipate higher prices in the future, the more quickly these prices rises occur and the greater their actual magnitude.

During the 1920s, Ludwig von Mises outlined the typical consequences of inflation. Mises began with first principles but directed a discerning eye towards the hyperinflation that ravaged Germany in 1920-23. War is the cause par excellence of inflation, and the cause of Germany’s hyperinflation of the early 1920s lay in the Great War. (As an aside, ask yourself: would total war that is waged globally, and the unspeakable loss of life and property that it has spawned, be possible without fractional reserve banking and the inflation it unleashes? Could war on such a scale occur under civilised monetary arrangements such as a 100% gold standard? The answer to both of these questions, it seems to me, is “no” – which is precisely why governments are such ardent proponents of fractional reserve banking and bankers hanker for war. See also Murray Rothbard’s outstanding Wall Street, Banks and American Foreign Policy).

Like other major warring counterparts except the U.S., Germany left the gold standard during the First World War so that it could obscure from its population the astronomical financial cost of the war. Freed from the shackles that civilised monetary arrangements clamp upon governments, central banks in Britain, France and Germany drastically increased their money supplies; and after the Armistice, the temptations for German politicians to inflate remained firmly in place. Most notable were the Allies’ demands for reparations, their continued blockade of Germany and the widespread famine in Germany and Central Europe these things caused.

Mises’ first insight was that during the early stages of inflation, the overall level of prices does not rise as much as the supply of money. If the money supply quadruples, for example, then consumer prices may only double. Why? Because individuals’ demand for money usually changes much less quickly than the supply of money. Relative to the supply of money, in other words, at the early stages of inflation the demand for money rises and much of the new money created by the inflation is added to cash balances. During these early stages, the demand for money offsets much of the upward pressure upon the overall level of prices. Inflation can rage, but in response the CPI can increase only modestly.

Mises’ second insight is that these modest increases of the price level will almost invariably go to the government’s head. Politicians will believe – American Republicans, are you listening? – that they can continue to increase the supply of money (indeed, they will think they can increase it more rapidly) and thereby finance their wars, subsidise their favourite groups and cover their growing deficits. But this process cannot continue indefinitely. Why not? Because the public’s response to the government’s inflation slowly but inexorably changes. Perhaps jolted by unexpectedly sudden and large rises of “sensitive” prices, such as petrol, individuals belatedly think to themselves something like “goodness me, the price of petrol is rising more than usual. Come to think of it, so too are the prices of many other things that I often buy. I’m beginning to believe that during the next several years prices will rise more rapidly than they have over the past several years.” The public’s expectations of relatively stable or modestly rising prices thus transform themselves into expectations of more rapidly rising prices.

Given these expectations, people will no longer (as they typically did in the 19th century) retain their money and wait for prices to fall. Instead, members of the public have a growing incentive to spend today and draw down their cash balances in anticipation of higher prices tomorrow. At this subsequent phase of inflation, when prices rise as quickly as or more rapidly than the supply of money, an increasing demand for money no longer attenuates price increases. Quite the contrary: a falling demand for money begins to accentuate price increases. Expectations, having detected and begun to adjust to the inflationary reality, now accelerate rather than moderate the overall increase of prices.

Who Crosses the Rubicon?

At this juncture, two fundamental questions present themselves. First, at what point do people’s expectations about the future level of prices change course? The answer is simple: a priori, there is no way to tell. In Germany after the Great War, this transition required four traumatic years of war and another 2-3 traumatic (albeit in different ways) years after the Armistice. In Anglo-American countries after the Second World War, the public took roughly 25 years (i.e., from 1945 to 1970) to realise that governments had encouraged inflation to rage – indeed, that “government policy” and “inflation” were synonyms.

Second, how do the inflators (i.e., politicians) respond to these changed expectations? Again, theory avails us little or nothing. We can say that if the government inflates less rapidly (as many Western governments did during the late 1970s and early 1980s) then the public’s expectations about future price rises will eventually moderate. To accomplish this task requires a sound grasp of reality, time and painful medicine – notions that, to put it mildly, are alien to contemporary Western politicians. This medicine typically includes sharply higher short-term rates of interest and the liquidation of the “malinvestments” accumulated during the inflationary boom. The necessary and restorative cure for the ills of an inflationary boom, in other words, is a recession (see Letter 66).

What happens if governments ignore the growing signs of danger and continue to inflate? Countries that have suffered hyperinflation, such as Weimar Germany and Argentina, provide strong clues. Money and prices spiral upwards at ever-increasing rates. Chaos ensues as members of the public think to themselves “the purchasing power of my money is disappearing even as I sit here. I must therefore spend all of my money immediately, on anything, it matters not what, and then barter these goods for those goods and services that I require.” Under these conditions the demand for money collapses and prices skyrocket towards infinity. For first-hand reports, ask any German above the age of, say, 90 years.

At the crest of the German hyperinflation, workers were paid twice a day and shoppers dragged wheelbarrows of banknotes into shops in exchange for a loaf of bread. Production collapsed – why bother to produce anything if the purchasing power of your money disappears before you can spend it? So too did confidence in the government. First they conscript your husband, father or brother to die in the trenches for nothing; then the Kaiser abdicates; and finally the currency and what remains of the established order disintegrates. People who had hitherto been conservative middle class professionals became paupers. Their trauma and desperation rendered them susceptible to the fantasies of madmen.

Today’s Powerful Constituency for Inflation

I do not anticipate hyperinflation, or anything remotely resembling it, because it is such lethal stuff (in the sense that it threatens the comfort and tenure of political and economic fat cats). Instead, Australians in 2005 have strong grounds to expect the continuation of moderate inflation. It is an excellent – because it is a subtle and hidden – means of robbing “have-nots” and featherbedding “haves.” In this respect it is hardly surprising that politicians in the Liberal-National coalition (and British Tories and American Republicans, etc.) should be enthusiastic proponents and skilled practitioners of inflation. What is astonishing is the fact that politicians who allege to champion people of modest means, such as Australia’s Greenlaborcrats, either turn a blind eye towards inflation or, in effect, demand more inflation. Are they hypocrites or idiots – or, more likely, a bizarre mixture of both?

Inflators, and those who sell goods and services to them, gain at the expense of those who stand further to the rear of the bogus-receipt spending queue. This is the attraction of inflation for its beneficiaries. And perhaps this explains the absence of concerted hostility from the many people whom inflation harms. Modern banking practices have highlighted its benefits to those (such as investment bankers and property developers) who are the initial recipients of disproportionate amounts of the funny-money conjured by banks. These practices have also obscured the destructive significance of inflation from those (such as retirees who try to subsist on interest income and people who earn relatively low salaries) who are far removed from credit-creating operations. The gains to inflators and their beneficiaries are visible and dramatic; the losses to their many victims are dissipated and obscured. Merchant bankers flatter themselves that they are “entrepreneurs” whose considerable remuneration derives from “risk taking” in a “free market.” The truth is that, of all the people privileged by the welfare state of credit, nobody is more lavishly subsidised, protected and featherbedded than they are.

In fairness, it is important to emphasise that bankers are hardly the only people who benefit from inflation. These days in Australia, the funds management industry depends upon it. (This, it seems to me, is a major reason why funds managers almost invariably respond credulously to virtually anything uttered by officials at the Treasury and RBA.) Consider something seemingly innocuous, good and necessary (the government chooses to call it “financial education”) that figures ever more prominently in the headlines and school curricula. It presently requires considerable knowledge, time and energy to preserve and grow one’s capital. Even the choice of a financial advisor presupposes some financial acumen. The government’s assumption – eagerly promulgated by funds managers – is that the Average Joe cannot provide sensibly for his old age.

The truth, of course, is that the average person – as well as the great majority of people of substantially below-average ability – can certainly do so provided that they can take the future purchasing power of their savings for granted. In a country with civilised monetary arrangements, the preparation for one’s retirement does not require any particular intelligence. Instead, it requires diligence. Preparation takes simple-to-understand but hard-to-practice forms such as the regular deposit of money into a savings account or the payment of premiums into an endowment-insurance policy. In a civilised society, it pays to be a creditor rather than a debtor; and it pays to be a bondholder at least as much as a stockholder. Given civilised monetary arrangements, in other words, the purchasing power of savings – and the streams of income emitted by bonds and stocks – rises steadily over the years. To increase the purchasing power of savings is to encourage more savings; and to promote savings is to till the ground for healthy economic growth and the steady increase of moral and material standards of living. The result is that savings will be – just as they were during the 19th and early twentieth centuries – sufficient to finance the retirement of industrious and disciplined people.

But we have been expelled from the monetary Garden of Eden. Warmongering Western governments long ago destroyed the gold standard, and just as the resulting wars destroyed countless lives and property, the resulting chronic inflation (properly conceived) has cumulatively destroyed the purchasing power of money. Do you think that 2.5% is an admirably low annual rate of “inflation” (as the mainstream conceives it)? If so, think again: prices which rise at this compound rate will, after just ten years, erode almost ¼ of the currency’s purchasing power. In Australia over the past 30 years, the CPI has averaged 6.3% per annum; as a result, governments have destroyed roughly ¾ of the dollar’s purchasing power.

Given limitations of time and energy, few people can gather the much greater amount and much more specialised character of the knowledge required to save and invest in an inflationary environment. Few, for example, possess the necessary knowledge, temperament, time and energy required seriously to analyse the individual companies whose shares are traded on the ASX or other Australian stock exchanges. Alleged concern for the typical member of the public and his plight – a predicament that, it is important to emphasise, has been created by governments – has led governments to take ever more direct charge of how individuals (and, more and more, those who invest on their behalf) must prepare for their retirement. If not for the government’s inflation, would Australia’s banks and financial services industry be anywhere near as large and politically influential as they are today? Would financial engineers command anywhere near the salaries they do? Would they remotely as numerous as they have become? Would they barrack as enthusiastically for big government as they do?

Three Conclusions for Value Investors

What to conclude from this analysis? First, the harder and more honest the money, the smaller will be the government. And the smaller the government, the fewer and less significant will be the wars it wages. Politicians, it seems, are genetically programmed to lie, cheat, steal and kill; but the more meagre their source of finance then the feebler their ability to prey upon people within and beyond their realms. Our Victorian forebears demonstrated that hard money means sound finance, growing wealth and durable peace. The pity is that their descendants have utterly disavowed this precious inheritance.

What, then, to do? The second conclusion is that, when pondering inflation and deflation, and the recurrent debates about them, it is essential that investors recognise something that utterly escapes today’s politicians, commercial and central bankers: increases in consumer and wholesale price indices on the one hand and inflation on the other are distinct things. Like value and price, they eventually regress towards one another; but at any given instant they may diverge (sometimes by a wide margin). Alas, the Reserve Bank of Australia – and countless economists, politicians and market commentators and participants – regard these two things as synonyms. They use the word “inflation” to describe increases in the general level of prices of raw materials, finished products and wages. Conversely, deflation conventionally denotes a decrease in the general level of prices. Using these definitions, the “headline” rate of inflation in Australia averaged roughly 2% per annum between January 1990 and December 1999, and since 1996 has remained below or within the Bank’s target range of 2%-3%. Australia, everybody consequently seems to rejoice, is a “low inflation” country; accordingly, the employees of the RBA are heroes and the leading lights of the Liberal-National coalition government are competent economic managers.

“Low Inflation Keeps Pressure Off Rates” (The Age, 27 July) is a typical example of this confusion. It stated that “inflation dropped slightly in the June quarter despite soaring petrol prices, improving the chances of interest rates staying on hold when the Reserve Bank meets next week. The Consumer Price Index (CPI) grew by just 0.6% in the in the June quarter, down from 0.7% in the March quarter, putting Australia on track for an annual rate of 2.5%. The Treasurer, Peter Costello, said the result, which was lower than expected, showed Australia continued to enjoy low inflation. ‘The medium-term outlook is for inflation to remain moderate,’ Mr Costello said in a statement. ‘Well-anchored inflation expectations have helped to contain the impact of high oil prices, and price pressures in the construction industry should continue to ease.’” Interestingly, the wording of “Inflation Surprise Keeps Lid on Rates” (The Australian, 28 July) is almost identical – and suggests that Australian journalists’ real job is mindlessly to parrot politicians and governments’ press releases.

The trouble is that today’s mainstream defines inflation in terms of one of its several possible consequences rather than its single and definitive cause. Inflation, in other words, never refers to an increase in the supply of money. Attention is thereby distracted from monetary expansion, the RBA’s sole responsibility for this intervention and the Liberal-National coalition’s privileged consumption and distribution of its alleged benefits. This choice of definition is no matter of mere semantics. “The semantic revolution which is one of the characteristic features of our day,” said Ludwig von Mises, “has also changed the traditional connotation of the terms inflation and deflation. What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.”

And so it has proved. Depending upon one’s definition of the money supply (which is a notoriously slippery concept and thus very difficult to quantify), inflation in Australia averaged closer to 6-7% per annum during the 1990s and as much as 10% since 2000.   To take one example, the RBA’s measure of “broad money” grew from $A257 billion at the beginning of 1990 to $A472 billion at the beginning of 2000, i.e., at an annualised compound rate of growth of 6.3%. More recently, inflation in Australia has accelerated: broad money grew 10.6% during 2002, by 9.4% during 2004 and at an annualised compound rate of 8.1% between January 2000 and March 2005. Other measures of money supply produce still higher estimates of inflation. Clearly, then, when it is properly defined as an increase in the money supply, then inflation presently is – and has long been – much more pronounced than central bankers, politicians, economists and investors recognise. Because practically everybody misconceives inflation, its sole creators are lauded and sometimes even revered. Like the firebug who joins the Rural Fire Brigade, central bankers receive kudos for “fighting” a fire they themselves have lit.

From this distinction follow some sobering implications. It is not just the prices of goods and services that can rise as a consequence of inflation: so too do the prices of stocks, bonds and real estate. Market participants rejoice when the prices of assets levitate. But very few recognise – and if they did, even fewer might care – that these increases are to a significant extent a consequence not of business and investment acumen but of banks’ insidious and relentless debasement of money. Further, inflation sometimes begets bull markets and at other times puts a fire under the prices of goods, services and wages. From one era to the next, in other words, the river of inflation can follow different channels. In 1975, it produced relatively high food prices and low stock prices; but in 2005, it has produced comparatively low food prices and high stock prices.

This conception also helps to reconcile something that is otherwise difficult to comprehend: the co-existence in recent years of a growing economy (as conventional national accounts measure it) and quiescent (by the standards of the 1970s) CPI. Inflation usually causes prices to increase. But it need not always or immediately do so. If technological improvements or organisational efficiencies or a flood of imports or good old-fashioned discipline exert a downward influence upon prices, but an increase in the money supply exerts an upward influence, then only a small overall increase of prices may occur. As a result, during times of significant inflation (properly understood), wages and prices may increase modestly or not at all. According to Friedrich Hayek, Wilhelm Röpke and Murray Rothbard, precisely such a situation occurred in Europe and the U.S. during the Roaring Twenties (see in particular Wilhelm Röpke, Economics of the Free Society, Libertarian Press, 1937, 1994, ISBN: 0910884285 and Murray Rothbard, America’s Great Depression, Richardson & Snyder, 1963, 1984, ISBN: 0836206347).

This situation has seemed to recur since 1990. These two periods – the 1920s and 1990s-2000s – thus suggest a crude generalisation and a third conclusion. Periods when aggressively interventionist central bankers stabilise the general level of prices (i.e., when the CPI rises at a politically acceptable compound rate of no more than 2-3% per year) tend to be characterised by speculative urges and gilded prosperity. The acclaim showered upon prominent central bankers such as Benjamin Strong and Alan Greenspan lulls market participants – and central bankers – into complacency; and this inattentiveness gulls both investors and policymakers into costly blunders. Like all interventionist objectives, a stable level of overall prices has unintended consequences that end in tears. When the boom ignited by the central and commercial banks’ aggressive interventionism ends, it does not cause difficulties: it reveals problems that inhered all along in the policy of inflation (properly defined). The characteristic feature of booms fuelled by inflation, then, is not that they are periods of profitable business; rather, they are irrationally exuberant times when scarce capital is squandered on bad investments. No thanks to the policy of price stabilisation, which the great and powerful mistakenly call “low inflation,” we seem to live in such times.

Chris Leithner


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