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It is clear, despite the invidious consequences deduced in Part II, that the conventional definitions of inflation and deflation will not be dropped. Quite the contrary: perusal of mainstream newspapers, Hansard and politicians’ statements outside Parliament, academic journals and the monthly and quarterly statements of the Reserve Bank of Australia, Reserve Bank of New Zealand and other central banks demonstrates that these definitions and habits of thought and policies that follow from them are as firmly entrenched as they have been since they coalesced in the 1940s. To give but one of a virtually limitless number of possible examples: The Weekend Australian Financial Review (11-12 May) reported that “in a pre-emptive strike against inflation, the Reserve Bank of Australia raised the official cash rate by 0.25 percentage points to 4.5 per cent.”
Accordingly, a range of critical implications following from the Austrian School insight that inflation is an increase (and deflation is a decrease) in the stock of money and money-substitutes remain almost totally unrecognised by today’s market participants. First, inflation (in the Austrian sense of the term) causes imbalances between the temporal structure of production and consumption; and the inflation that raged during the 1990s and which made its presence felt on equities markets during the late 1990s continues today (indeed, it was accelerated, particularly in the U.S., in the wake of the 11 September attacks). More generally, and part-and-parcel of their inflationist policies, governments and central banks can induce artificial and unsustainable booms simply by expanding the money supply or running a deficit (often in tandem) and willy-nilly purchasing goods and services. America in the wake of the 11 September attacks is a good example.
Second, bust inevitably follows a central bank’s extended embarkation upon a policy of inflation; and the greater the expansion of the supply of money not backed by savings the more severe the eventual bust (i.e., liquidation of the “malinvestments” undertaken during the boom). Alas, the bust that began in 2000 was aborted by the inflation that recommenced in early 2001 and which was accelerated in the wake of the 11 September attacks. Further, unless one truly believes that money and wealth can be conjured out of thin air, bust may be postponed but not delayed indefinitely.
Finally, changes in prices have real (i.e., behavioural) as well as monetary causes. If real causes (such as rapid technological improvements or organisational efficiencies or both) exert a downward influence upon prices but increases in the money supply exert an upward influence, then no visible change in the price level may occur. Given inflation, in other words, a bust will eventually occur whether or not producer, consumer and other prices are stable in the interim. The worries of Austrian School economists during the 1920s were not placated by the stable prices of that era; nor are similar concerns by contemporary “applied Austrians” such as James Grant, being allayed today.
Relative Prices and Margins
Inflation, as we have seen, distorts the temporal structure of production and deranges the market price signals of the producers and consumers who co-ordinate the structure. Most notably, the prices of labour, raw materials, machines, etc. in those industries (let us dub them “X industries”) in which entrepreneurs, armed with credit not backed by savings, seek to invest disproportionately are bid up during the boom. During the 1990s X industries included telecommunications, Internet/IT, biotechnology and mass media. Indeed, given their voracious demand for resources, wages and other costs in X industries increase to such an extent (or, equivalently, demand for their goods and services are over-estimated to such an extent) that the profit margins in these industries become compressed and perhaps eventually destroyed. Inflation, in other words, will tend not only to increase prices in general; it will also distort relative prices and relations of one type of price to another. Inflation will tend to raise all prices but wages and other costs in the X industries will tend to increase faster and further than wages and costs in “Y industries” (i.e., those industries which entrepreneurs, armed with credit not backed by savings, tend to ignore during the boom). During the mania of the 1990s, Y industries comprised the allegedly low-technology “Old Economy” of mining, agriculture, wholesaling and production of unfashionable and disagreeable goods and services such as funerals and collection of refuse. In short, the inflation-induced boom will be more intense in some industries than in others, i.e., in the X industries rather than the Y industries.
On the other hand, the essence of the bust, i.e., the adjustment in the wake of the unsustainable boom, is the reduction of prices, wages and costs in the X industries relative to Y industries. This occurs in order to induce resources to move back from the unsustainably swollen X industries into the relatively deprived Y industries. If bank credit contracts sufficiently, prices in both the X and the Y industries may fall. Indeed, if as a consequence of a precipitous fall of credit the money supply contracts (i.e., deflation occurs) then prices will fall. Regardless of the extent of the credit crunch, however, prices and wages in the X industries will fall relative to those in the Y industries. In consequence, both the boom and the bust will be more intense in the X industries than in the Y industries.
Type I and Type II Busts
We are thus in a position to distinguish two types of busts. The first resembles the “classic” or old-fashioned bust whose vintage antedates the Second World War. Examples include the “good” (because governments intervened but lightly, market price signals were not distorted and recovery proceeded very quickly) Depression of 1920-21 in North America, and the “bad” (because governments intervened massively and ineptly, market price signals were tremendously distorted and “recovery” occurred only through the mass militarisation and slaughter of the Second World War) Great Depression of the 1930s. In the “classic” boom inflation occurred, prices consequently rose in a general (if not completely across-the-board) fashion and the prices of capital goods (i.e., “lower order” goods in terms of the temporal structure of production) rose more than the prices of consumer (i.e., “higher order”) goods. Resources were thereby withdrawn from consumer goods industries and into capital goods industries. In short, and abstracting from the general increase of prices, relative to each other the prices of capital goods rose and those of consumer goods fell during the boom. The opposite situation occurred during the bust: the money supply decreased (i.e., deflation occurred); prices generally fell; and the prices of capital goods fell by more than those of consumer goods and thereby withdrew surplus resources from capital goods industries and redeployed them in consumer goods industries.
Abstracting from the general decrease of prices, relative to each other the prices of capital goods fell and those of consumer goods rose during the bust. The busts of the 1970s (and, to a lesser extent, 1980s) typify Type II busts. During the booms, capital goods prices still rise and consumer goods prices still fall relative to each other, and vice versa during the bust. The difference is that new (post-Smithsonian) monetary institutions and attitudes with respect to those institutions exist. Now that the gold standard has been completely eliminated, central banks can and do increase the money supply of money regardless of whether the business cycle is in boom, bust or some position in between. No contraction of the money supply, i.e., deflation, has occurred since the 1930s; and given present monetary arrangements and attitudes deflation in the future is difficult to envisage. Now that the money supply always increases, prices of raw materials, producer goods and services, consumer goods and services and financial assets are always increasing, some more than others and at some times more than others.
In James Grant’s words, “central bankers may decry one form of inflation. But among the contributions of the Austrians is the insight that there can be an inflation of assets as well as an inflation of prices. In Wall Street and the financial press, inflation means one thing only: the CPI going up. But to students of the Austrian School, that isn’t even half of it.” The Type II bust, then, corresponds to the “stagflation” of the 1970s. Why did consumer prices rise during the busts of the early 1970s? Because the inflation generated by central banks was markedly higher in the 1970s than in previous decades. The money supply expanded by as much as 15 to 20 per cent in the United States in the 1970s, compared to 5 to 6 per cent in the 1950s and 1960s. Thus, the only difference between a Type I and Type II bust is a matter of degree. In both types of bust the relative pattern of prices remains the same.
Contemporary Delusions About Deflation
There is nothing wrong with declining prices. Quite the contrary: there is much that is right about them. Indeed, in a market economy and hard money such as gold (as opposed to today’s fiat money imposed by government) the prices of goods tend to fall gradually. According to Joseph Salerno (An Austrian Taxonomy of Deflation), “historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus throughout the nineteenth century and up until the First World War … rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the U.S. from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75 per cent per year, while real income rose by about 85 percent, or around 5 percent per year.” Hence Hayek’s insight that “capitalism created the proletariat, not by making anyone the worse off; rather by enabling many to survive who would not have otherwise done so.” In a free market, the rising purchasing power of money – i.e., the general decline of prices – is the mechanism that enables the great variety of goods produced to become accessible to many people. According to Murray Rothbard (What Has Government Done to Our Money?), “improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.”
According to today’s experts, however, a general fall in prices is unambiguously bad news. It is asserted that it slows consumers’ propensity to spend (why buy today if you can buy at a lower price tomorrow?) and thereby undermines the rationale to invest in plant and machinery. “Underconsumption” sets a slump in motion; and as the slump further depresses the prices of goods the pace of economic decline is intensified. An example, in the form of a profile of one of the U.S. Federal Reserve’s most stalwart fighters of “inflation” (in the conventional sense of the word), appeared as a Page One feature in The Wall Street Journal (8 May 2002). According to the profile, “recently his thinking has changed. The remarkable mix of low unemployment and low inflation in the U.S. in the late 1990s and an unsettling trip to Japan have [caused a transformation]. After last fall’s terrorist attacks, he worried more about the potential harm of deflation, which has hobbled Japan, and helped lead the charge to the lowest interest rates in the U.S. in 40 years.”
The article continues “there is a downside to price stability: the Fed must be equally vigilant against threats not just of inflation, but also of deflation, when prices and wages fall, severely hampering the [central] bank’s ability to stimulate the economy … That a die-hard inflation hawk now talks of the dangers of inflation going too low has raised eyebrows both inside and outside the Fed. Yet people who have watched [the “hawk”] consider the apparent change consistent with a commitment to price stability, which means battling both inflation and deflation. ‘It’s not a change of heart’ says [a former Fed Governor]. ‘It’s a change of circumstance.’”
Some Implications For Value Investors
Looking at inflation and deflation from the Austrian School perspective has profound implications for investors. The first is that inflation – and not deflation – is the inevitable consequence of contemporary monetary institutional arrangements. Today we live, in other words, with central banks’ current inflation and the consequences of their past inflation – not deflation. James Grant, in an outstanding interview, dubs current arrangements the “welfare state of credit.” According to Mr Grant “it is a structure of regulators, lenders, and borrowers, and the system is dedicated to stability … The system is established to avoid runs, panics, depressions, financial turmoil, and other upsets. The idea is to head off the contractions before they happen. It is the financial counterpart of the more familiar welfare state of income and of labour.” The consequence of this welfare state is “to promote great bull markets and excessive risk taking in the financial and investment market.” The fiscal and labour welfare states generate the perverse effect of feeding the very diseases they are supposedly trying to cure.
In a similar way, the welfare state of credit feeds speculative frenzies and excessive risk taking in the financial and investment markets, while attempting to prevent the losses associated with excessive risk taking. It creates the boom that causes the bust, but it attempts to abolish the bust. The long-run consequence is to subsidise instability and economic stagnation in difficult-to-predict ways.” Second, the relevant question to ask about inflation relates not to any subsequent stability of prices (including, critically, the price of credit) but to the validity, reliability and integrity of those prices. Stability in producer and consumer prices is not an end-all. It can and does mask distortions introduced by easy money. Inflation obscures and distorts the signals normally transmitted by prices in unfettered markets. Investors would therefore do well to ask themselves: given government intervention, do current prices (including the prices of loans) convey accurate information? Acting on them, would individuals make reasonable choices? Or, misled by subsidised market rates of interest, would they undertake “malinvestments” which must be liquidated when ebullient conditions end?
Third, what is needed for a sound expansion of production and attendant increase in living standards is additional capital goods – not additional consumer expenditure and certainly not more money and credit unbacked by savings. Accordingly, the “recovery” presently apparent in some parts of Australia is to a significant extent illusory. Investment projects which subsidised market rates of interest bring to life can be continued only so long as credit remains available at sub-natural rates of interest. It is this margin between the subsidised rate and the natural rate that misleads entrepreneurs and investors and gives their investment projects the false appearance of profitability. It also misleads consumers and gives their shopping sprees the false appearance of sustainability. When the boom ends, as it inevitably must, the bust does not cause difficulties: it merely makes apparent difficulties inherent all along in inflation.
The trouble with gilded prosperity, such as that which has occurred in Australia in recent years, is that to a significant extent it takes the form of a boom induced by a central bank’s inflation. Such a boom period is not a period of good business: to a significant extent, and as has become painfully apparent to speculators-who-thought-they-were-investors in telecommunications, Internet/IT and media companies, it constitutes an incipient waste of resources on bad investments. Perhaps in several years this sobering point will also become apparent to today’s speculators-who-think-they-are-investors in certain “blue chip” equities and residential real estate in Sydney, Melbourne and Queensland’s Gold and Sunshine Coasts.
 
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