As we know the fed created huge sums of money in order to shore up the balance sheets of financial institutions. The assumption by many then as now is that this would lead to a burst of inflation. So, why aren't prices skyrocketing? Off the top of my head and standing on one foot I will try to answer that question.
For the purpose of this discussion I will define inflation as too much money chasing too few goods resulting in an across the board increase in prices. Credit is a derivative of money and must also be considered since it is also a claim on goods. Deflation would be the exact opposite: Too little money and credit chasing too many goods leading to falling prices. The definition was originated by Milton Friedman, more as a way of simplifying an understanding of inflation for the laymen than as a serious theory of the value of money. That he did elsewhere.
The Quantity Theory Of Money, or Monetarism, is the accepted monetary theory of our day. Most investors, economists, and political pundits, and probably you yourself, hold that a major increase in money and credit is inflationary and will inevitably lead to higher prices. Irving Fisher formalized the theory in the 20's and Milton Friedman expounded on the theory in the 70's. His clear and simple way of explaining the nature of inflation was grasped easily by professionals and laymen alike. Milton Friedman almost single handedly waged and won the war against inflation during the 70's, a period when we needed him most. This is why I list Milton Friedman as one of those that had a profound influence on me not only in economics, but as a writer. But I am not a Monetarist. Monetarism is not wrong, it is simply incomplete.
There is another theory of money that challenges the Monetarists theory of money that I believe makes a lot more sense -- one that explains why we are not experiencing a lot higher prices given the huge increase in the money supply. It is the Subjective Theory of the value of money as formalized by Ludwig Von Misses and the Austrian School of Economics. This theory holds, in its simplest form, that money derives its value not from the quantity in circulation, but the value individuals place on money in exchange for other goods.
What always leads to price rises or price declines is the hoarding or dishoarding of money by the population at large. Increases in the money supply can influence the value people place on money but it is only one factor in calculating the future value of money. The Monetarist School sees an increase in money as a cause of higher prices, where the Austrian School does not. In the end it is the actions individuals take themselves based on their value of money that lead to higher prices, according to the Austrian School.
If Ben Bernanke dropped dollars from helicopters tomorrow, Friedman would say that inflation would result. Von Mises would say it would depend on what individuals did with the money and to what degree. If they put it under their mattress no inflation would occur. If they spent it, Monetarists would compute the amount of the increase in new money and predict an inflation rate based on the percentage of increase in the quantity of money. Von Mises would suggest that it is just as likely that all money previously created would loose value as individuals loose confidence in all paper claims that serve as a medium of exchange. He, I believe, would conclude that hyperinflation was more possible than progressive inflation; that a breakdown of the monetary system would be more likely than a discounting of the value of money leading to progressively higher prices. Zimbabwe is good example of that.
At any time individuals decide to suddenly save rather than spend, prices tend to fall irregardless of the quantity of money in circulation. Whenever individuals decide to increase their spending sharply and suddenly, prices tend to rise. The Monetarist theory of money only partially explains the phenomenon of inflation and deflation. It was very correct in the 70's within that particular context. It is not doing so well in present day America as the context has completely changed.
In the 70's the Federal Reserve printed vast amounts of money that went directly into consumption. Today the fed has printed vast amounts of money that has gone directly into savings by financial institutions. The fed dramatically increased the money supply beginning in September 2008. According to Friedman, prices should respond within 9 to 12 months. So we should have seen a marked increase in prices by the fourth quarter of 2009. We did not. In January we saw a 2.6 year over year increase in the CPI and the core rate actually declined for the first time since the early eighties.
Many economists suggest that we do not have an inflation problem now but we will a year or two from now. I know of no theory that can project prices several years in advance. Those that are suggesting higher prices are inevitable sometime in the future are simply guessing. There is no causal link. The fact is, the money supply was increased from 1 trillion three hundred and seventy five billion dollars to one trillion seven hundred and 6 billion from 9/15/08 to 12/29/08. If I'm not mistaken that is the largest increase in money supply by the US Federal Reserve, ever. Yet, inflation has remained low.
What those arguing that prices will rise sharply in the future are actually saying is that when the money that the fed printed begins to be used for consumption, we will have an inflationary problem. This would be true if and when it happens. But this is the Austrian School's view of the world, not the Monetarists.
If all of a sudden, for whatever reason, people begin to dishoard money, its value will fall and prices will rise. It is human action that dictates prices not the quantity of money. Most point to gold and other hard commodities vrs. fiat money all over the world over the last many years as signs of inflation. The value of most currencies have fallen in relation to gold as individuals dishoard paper money and hoard gold and most other commodities. But, this is not inflation. Consumer prices have remained stable. That is because the new money created is not chasing goods. Fiat money has been targeted towards gold and other assets. This suggests that an increase in the money supply is "not always and everywhere" inflationary. It does not always lead to a general across the board increase in prices. It may show up elsewhere such as stocks, real estate, or commodities -- or it may not show up at all.
The Subjective Theory Of Value does not dispute the fact that if a government prints up progressively more and more money and throws it into circulation the monetary unit will probably fall in value. It usually does -- but not always. The cause and effect is not one of increased money equals increased prices. It is that a change in human action that values money less leads to increased prices.
The distinction is an important one. It goes to the heart of today's monetary argument. Is inflation based on the single act of increasing the money supply? Or is it based on how individuals perceive its increase and how they act on it? I come down on the side of Von Mises on the subject. If a majority of people today believed their money was going to depreciate by 50% next year in terms of goods, in my book, (or should I say Von Mises's book -- which happens to be called Human Action) they would begin discounting the monetary unit today. My conclusion is that they do not believe that. Prices have risen in the last year, but there is no panic out of currencies in relation to goods. And interest rates, the price of money, have remained stable rather than soaring to discount future depreciation.
Monetarists will argue that it is just a matter of time. That the newly printed money will eventually start chasing goods and bid up prices. Yet, that is not the expectation of the markets. Markets know there is not "too much money or credit chasing too few goods". The bond market confirms this and long term inflationary expectations have remained in check. This could all change in a matter of minutes, but it would not have to do with the quantity of money. If prices did begin to increase dramatically a vast increase in the quantity of money could not be the trigger -- that trigger has already been pulled. It would be due to a sudden change in individual perceptions of the value of money going forward -- and this is never predictable. The big difference between Monetarism and the Subjective Theory Of Value is the first believes it can predict inflation or deflation. The latter knows it can not.
Even during the gold standard there was inflation and deflation. It was usually due to unexpected gold strikes or unexpected economic contractions. The gold standard served the nations of the world well for centuries. Money remained fairly stable. There were many sharp depressions but they were over quickly and they were within the context of continuous and dynamic growth. The years of the gold standard were the years of the Industrial Revolution.
Sir Issac Newton, one of the smartest men who ever lived, helped establish and preserve the gold standard during the mid 1600's. Some of the greatest minds in England's 17th century such as Adam Smith and John Locke continued to champion the gold standard which ushered in their Industrial Revolution. The Founding Fathers, no slouches in their own right, established the gold standard as the monetary system of the United States Of America and wrote it into the US Constitution. It was the monetary system that led to the American Industrial Revolution. But Woodrow Wilson decided he knew better than most of the greatest minds that ever lived, and discarded the gold standard and replaced it with the edicts of the Federal Reserve Board.
You don't have a monetary system that lasts centuries because it is ineffective. True, we had a lot of economic normal ups and downs, but the worst of those downturns lasted only a short time, not a decade as did the Great Depression or the malaise of the 70's. More importantly, the value of money always stayed fairly constant during those years which is all that the gold standard guarantees. It never guaranteed economic Utopia. Under the fiat standard we have lost 98% of our money's value since the government replaced the gold standard with the Federal Reserve System and to this day we still have panics and severe recessions.
For sure, we know that in all things monetary and economic, context changes and today is no exception. Today, I am less concerned about progressive inflation and more concerned that the fiat standard we have established is failing. Many are calling for fundamental monetary reform. But, from this point it would be easier to improve the fiat system than to replace it. (See my article "Are The Fiat And Gold Standards Converging" by clicking "more articles" at the top of this page.) Fiat currencies all over the world are loosing confidence. Gold is reflecting this.
A medium of exchange must be a medium of trust to be a lasting medium. Money must be dependable. The artificial increase in the money supply by governments undercuts that trust. This is the case today. But it is not the fed that is the real threat, it is irresponsible politicians in general.
Inflation has been held in check by the knowledge that money can be pulled out of the system as fast as need be under a fiat standard. The real threat is the viability of the entire world fiat system. If trust is to be regained it needs to start with fiscal responsibility. Monetary policy is far "easier" to control by an independent authority than is government spending by a world of spendthrift politicians. The debt that has been created by most nations today is a far greater threat to the economy than the threat of inflation. Monetary reform is required, I agree, but not today. It is fiscal reform that is required.
No monetary system, not the fiat standard nor the gold standard can survive reckless tax and spending policies by government. Our first task is not fighting inflation. Our first task is reigning in deficit spending and addressing unfunded liabilities. Without addressing those problems a mere increase in prices -or decrease - is dwarfed by the potential of a prolonged recession such as has occurred in Japan over the last two decades and the toll that would take on this country. Or worse a chain reaction of debt defaults that could bring the entire international monetary system tumbling down.
It is important to keep an eye on inflation, and deflation, and the fed, and the dollar. But I suggest that we as a nation, indeed, we as a world, need to sharpen our focus and deal immediately with government spending, government debt, government entitlements, and tax policy. Long before any action need be taken on monetary reform to reign in inflation we need to address our fiscal problems. No monetary reform will be meaningful or lasting without fiscal sanity. I suggest we stop wagging our fingers at the Federal Reserve and redirect them toward those that want to spend more on government programs with no way of paying for them.
Paul Nathan has specialized in gold and gold stocks and has written extensively on monetary and economic matters since 1968. He also writes a weekly blog and can be contacted at firstname.lastname@example.org
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