Sorry not to be able to reply earlier but have been busy. We seem to have hijacked Steve’s thread. Thanks for both your and Steve’s comments they have given me a great deal to ponder.

>If you give him credit from thin air (as oppose to credit from existing pools of savings), wouldn’t that give him an unfair claim on existing input resources in the economy?<

Credit is a two way street, yes there is the initial claim on resources but eventually the borrower has to give the resources back. He may push the prices of things up initially but afterwards the resources are sold back to the community pushing the prices down. The money that has to be borrowed has to be paid back: A zero sum game from the point of view of the lender’s capital. The profit the lender makes is from the rent of his resources. The fly in the ointment in this issue is the difference between nominal and “real” value. The credit is priced is nominal dollars while the resources consumed are real. Deflation results in more capital being given back to the lender than loaned by the debtor: inflation the opposite. It is unfair to ask lender to subsidise borrowers, but is it fair to debtors to pay a premium above interest to lenders? Both are unfair if the state of affairs is deliberately engineered.

The problem of course is that nominal/real ratio is different at time(1) as opposed to time(2). Most modern economists, especially those of the left, view manipulation of this ratio a necessary evil. Currency debasement is seen as a lesser evil than unemployment. This of course is true in the short term—and hence favoured by politicians—but disastrous in the long term. In the economies which have most embraced this pseudo-Keynesism, the populations are terrible savers as it is a loosing proposition.

The problem I see with the fixed standard crowd—be that fixed to gold, bananas or whatever–is that money supply is limited to the availability of that particular asset and hence reflects the ratio of demand of that good in relation to supply of other goods. Say that we were to use the gold standard. Let’s say that real gold reserves were going to grow at 4% per year but the economy grew at 8% in real terms, there would have to be an appreciation in the price of gold. Sure the price of gold may be nominally fixed but in view of more goods chasing a limited supply of gold there would be apparent deflation. Great from the perspective of the gold owner however from the point of view of the producer there would be real inflation since it would take more widgets to purchase a given price of gold: there is less purchasing power per widget. I don’t see why nominal asset appreciation is bad in every instance except for that asset by which one backs one’s currency.

Sure it’s very difficult to inflate under a fixed standard but it is also difficult to lend especially in the presence of high demand except at exorbitant rates. Personally I feel that a specific asset linked currency has pluses and minuses, the main minus being potential economic growth retardation. Personally I’d like to see money supply being regulated by CPI. The role of a central bank should be to extend credit while at the same time keeping CPI as close to zero as is possible

Assuming CPI can be accurately measured—and that’s a big if—then I’d like to see loan repayments based on the following equation.

Loan outstanding=Principal x CPI x interest-Payments

Now wouldn’t that lead to an interesting state of affairs? It’s in everybody’s interest then to then keep CPI stable and it’s in everybody’s interest to see that the CPI is accurately measured. In periods of inflation peoples loans would increase thereby maintaining their real value putting a break on further borrowing. The psychological effect of seeing principal being eroded would be a disincentive to too restrictive a credit supply. The other bonus of course is that the currency would be sound.

Sorry Steve for hijacking your thread. I wouldn’t mind a discussion of how you think we should get out of this mess when you’re up to it.

> “If the producer produces more of a good which the community want, the price of that good will go down thereby balancing the initial inflation.”

Do you think this can really happen that nicely and perfectly in the real world? If you give that producer newly printed money from thin air, do you think the uneven and un-predictable side-effects of price inflation of other goods and services will fit hand in glove perfectly with the possible price deflation of one widget W such that the overall price effects on the economy is zero?

This is what is happening right now in the ethanol industry in the US. By subsidizing ethanol production from corn, no doubt consumers in the US have access to cheaper ethanol. But look at the side-effects- it contributes to the food price inflation world-wide, especially corn. Recently, Mexicans are protesting against sky-rocketing corn prices, which is their staple diet.

> “The real problem arises when one makes a claim on resources without any corresponding increase in production(asset inflation)”

Isn’t this the case with widget W producer? If you give him credit from thin air (as oppose to credit from existing pools of savings), wouldn’t that give him an unfair claim on existing input resources in the economy? Wouldn’t that be unfair to the other producers in the economy who do not have access to that freshly printed stack of money?

> “but by the same token he produces widgets which would not have existed without the credit.”

Why would he need credit that comes from thin air in order to produce that widget? Wouldn’t credit that comes from existing pool of savings be more fair?

> “I’ve been thinking about Steve Keen’s thoughts on inflation and am more opposed to them as time goes on. Firstly because it will entrench the wealth inequality that is present in Australia.”

I agree with you on that one. Inflation will result in re-distribution of wealth and mis-allocation of resources in the economy.

Here’s a few: Overconfidence in one’s entrepreneurial abilities, misreading the tastes of the market, faulty guestimating of the future. unrealistic appraisal of demand. Price is only one of the factors. Indeed most producers anticipate the effect of inflation in their projections especially when inflation is predictable. I think price setting by the government is a far more dangerous influence on capital allocation since it divorces price from economic reality.

Back to our widget producer, it is true that he does push up the prices of goods required in the production of the widget ,but by the same token he produces widgets which would not have existed without the credit. If the producer produces more of a good which the community want, the price of that good will go down thereby balancing the initial inflation. (We can debate this point ad nauseum but that is my current belief)

The real problem arises when one makes a claim on resources without any corresponding increase in production(asset inflation), or if one produces goods that the community does not need. Extending credit to such operations–or propping them up–is inflationary per se. Linking CPI to credit creation is not inflationary , it is pretty much the same as asset backing your currency.

I’ve been thinking about Steve Keen’s thoughts on inflation and am more opposed to them as time goes on. Firstly because it will entrench the wealth inequality that is present in Australia. The financially intelligent will move their funds to assets while the unsophisticated will keep their assets in a form that will depreciate. The property speculator will be rewarded while the humble family saving for their first home will fall further behind in the wealth stakes. Government sponsored inflation is really a system of privatising profits and socialising losses. Furthermore it promotes culturally entrenched moral hazard. People who take high risks should expect a real risk of failure by occasionally failing. Government should not let you keep your profits while protecting you from losses. That will definitely lead to capital misallocation.

> It seems both of us are missing points. The entry of the new widget maker increases
> competition amongst widget makers, resulting in lower prices in the widgets; increasing
> the purchasing power of the consumer. The widget producers get their margins squeezed.

That may not always be the case. That’s true if the new entrant is able to produce more efficiently then their competitors. Even then, it is only that widget that enjoys price deflation, while the side-effect causes inflation in other industries.

Let me elaborate more on my earlier point. Let’s say producer A somehow receives $1 billion of newly printed money. He then starts producing widget W. A huge part of the input cost of producing widget W is oil. Therefore, producer A, with his increased purchasing power, caused oil prices to rise. Therefore, his entry into the widget W business results in rising oil prices. Let’s say producer A is able to produce more efficiently than his competitors and sell widget W at a cheaper price. That’s fine, but here’s a side effect to this.

Because oil prices has increased, it will affect the other industries (that depends on oil as an input cost) in the economy as well. Say, because of the surge in oil price, the trucking industry has to raise prices to cover their margins. This will then flow on to the prices of all goods that are delivered by trucks, causing them to increase in prices. In fact, every other industries that depends on oil will be affected.

Therefore, producer A (and their customers) is the primary beneficiary of monetary inflation, but the other industries is disadvantaged as a result as a side-effect.

In this example, the important concept to understand is capital structure. Monetary inflation in this example causes distortion because it results in increased production which cannot be supported by the current configuration of capital structure in the economy.

>The other thing I don’t understand is why is deflation such a good idea?

Firstly, there are many kinds of deflation (I suggest you refer to this document: An Austrian taxonomy of deflation). Some of them are beneficiary and some are harmful. The price deflation due to increased productivity is the beneficial deflation. It is precisely this kind of deflation from China that enables Australia (and US, Britian, etc) to enjoy all these years of low price inflation and high consumption. If not for China, with the RBA is printing money, we will all be suffering severe price inflation by now.

> [Deflation] punishes borrowers and rewards savers

First, this assumes that interest rates are not free.

You see, we have been so used to controlled interest rates that we forget that in a free monetary system (fixed supply of money and price of money set by free market), interest rates are free to move. In times of good deflation, it discourages borrowing and encourages savings. As a result, interest rates will fall. It provide a disincentive to borrow and an incentive to use current savings for purposes of investment. In that sense, this falling of interest rates is some sort of automatic stabilizers that reduce the debt servicing burdens of borrowers.

Wouldn’t good deflation be beneficial? It is a fine way to discipline idiotic borrowers! It puts a check on idiotic borrowers from borrowing money for unproductive purposes (e.g. speculative purposes).

As Rothbard has said, “rather than a problem to be dreaded and combatted, falling prices through increased production is a wonderful long-run tendency of untrammelled capitalism. The trend of the Industrial Revolution in the West was falling prices, which spread an increased standard of living to every person; falling costs, which maintained general profitability of business; and stable monetary wage rates—which reflected steadily increasing real wages in terms of purchasing power. This is a process to be hailed and welcomed rather than to be stamped out.”

> However the capital structure is a result of the decisions of idiotic borrowers given
> finance by idiotic central bankers. Capital misallocation is not just a result of loose
> financing, it is also a result of bad decisions of where to invest the capital, something
> the capitalist has a great deal of say in.

Just a question for you to think about: Why would there be bad decisions in the first place (which result in capital mis-allocation)? You see, prices conveys a very important piece of information for the economy. It tells the producers what to produce and what not to produce.

For example, if I am thinking of entering widget W business, and I see that widget W is falling in prices because of competition (i.e. a lot of resources in the economy is being allocated to producing widget W), would I want to enter that business? No!

However, I would want to enter into the business where prices are high and rising because of the potential of earning high profits. Rising prices tells the economy that insufficient resources are being allocated to the production of that widget. As more producers starts to produce widgets that are rising in price, such increased competition will cause a deflation of prices, which discourages additional allocation of resources into that industry.

But once you introduce monetary inflation, you distort prices. When you distort prices, an important piece of information is being distorted. That in turn result in mis-allocation of resources (see How is inflation sabotaging our ability to measure the value of things?.

When “A” receives the newly printed money, he has to spend it on the input costs (say, for example, oil) to produce widgets. Consequently, the price of the input costs (in this case, oil) has to rise. The problem is that this increase in the price of oil will cause the prices of other widgets that depend on oil as an input to rise.<

It seems both of us are missing points. The entry of the new widget maker increases competition amongst widget makers, resulting in lower prices in the widgets; increasing the purchasing power of the consumer. The widget producers get their margins squeezed.

The other thing I don’t understand is why is deflation such a good idea?. After all isn’t deflation negative inflation? All that having a fixed supply of money and credit, relative to an increasing supply of goods and services does is push up the real price of money. i.e more productive units are required for the given of money. It punishes borrowers and rewards savers: The opposite of inflation. I think both are variants of the same thing and both are vices.

I agree with you that CPI figures are distorted at the moment. The CPI figures produced in most of the West are a outright lie. However the Bundesbank approach of the 50’s and 60’s, in keeping money supply linked to an accurate–and honest– CPI target seemed to be the right one to me. By the way Ludwig Erhard was heavily influenced by Austrian thinking, particularly through the Frieburg school.

Where Austrians I think beat the Keynesian’s hands down is in the importance of capital structure in the sustainability of an economy. However the capital structure is a result of the decisions of idiotic borrowers given finance by idiotic central bankers. Capital misallocation is not just a result of loose financing, it is also a result of bad decisions of where to invest the capital, something the capitalist has a great deal of say in.

Live withing in your means is not advice meant for a central banker but a prospective borrower; as is plan for a rainy day. The fact that many borrowers have failed to heed this advice in the current climate is something I feel merits further study. Indeed the psychological weakness that lead people into irrational manias is an area which I feel economics would do well to put more effort into. Insights into the mechanisms of collective stupidity may provide us with remedies to future bubbles. My own take on the Great depression is that it started off as a liquidity squeeze in the face of great demand, and ended up being in the end a failure in aggregate demand. The people who were spendthrifts in the past ended up being to thrifty to spend.

Money is a medium of exchange which is meant to represent value. By linking the value to the supply of a fixed good–lets say gold–its value rises and falls relative to Gold’s relationship to the rest of the economy.

First, we need to agree on definitions. The Austrian definitions for inflation is different from mainstream definition. The Austrian definition for inflation (which is the definition used by mainstream economist before WW2) is: increase in supply of money and credit. The mainstream definition of inflation is: increase in the general price level. To avoid confusion, let’s call the Austrian definition as “monetary inflation” and call the mainstream definition as “price inflation”.

> “In order for there to be inflation there has to be a greater increase to money supply relative to the supply of goods and services. If they are matched there is no inflation.”

In an economy which is growing, prices should be falling if the money supply remains constant- that is the whole point of economic growth. If prices remains constant due to money supply increasing at the ’same’ rate (note the quotation) as the increase in goods/services, then prices is being distorted (i.e. prices is being prevented from being deflated due to monetary inflation).

In a free market, prices conveys a very important piece of information. It plays an important part in telling producers how to allocate resources to produce widgets in an economy. If prices is being distorted, we can be sure that it will result in net loss to society due to mis-allocations of resources.

In reality, it is not always possible to engineer constant price levels by matching increase in money supply with increase in supply of goods and services because monetary inflation affects the prices of goods and services unevenly at different rate. Furthermore, the general price leve is a fallacious concept (see How much can we trust the price indices (e.g. CPI)?).

> “Suppose A is in receipt of de novo central bank finance and uses the funds to make widgets. A gets first claim on a community’s goods and drives up prices, decreasing the purchasing power of B…”

You’ve missed an important point.

When “A” receives the newly printed money, he has to spend it on the input costs (say, for example, oil) to produce widgets. Consequently, the price of the input costs (in this case, oil) has to rise. The problem is that this increase in the price of oil will cause the prices of other widgets that depend on oil as an input to rise.

> “I think the emphasis by many Austrians is on idiotic bankers where I would like to see more of an emphasis on idiotic borrowers.”

This problem can be solved without intervention by government into the free market.

Suppose we have an economy with constant money supply and the prices of money (interest rates) is being determined by the free market. Let’s say there’s too many idiotic borrowers in society. What will happen?

Those idiotic borrowers will fight against each other to borrow a fixed supply of money. Because the market for money is free and the supply of money is fixed, the prices of money (interest rates) will rise because idiots will bid against each other. The more idiotic borrowers there are, the higher interest rates will rise. According to the basic law of supply and demand, when that happens, higher prices will act to curb the demand for money of those idiotic borrowers.

Today, money supply is not fixed and the price of money is not free. That’s why idiotic borrowers exists in the first place- the market is not free to use prices as a lightening rod against idiotic borrowers.

Thanks for your replies. I’m broadly sympathetic to the Austrian economic school and its ideas. However I don’t think that an increase in money supply automatically leads to inflation. In order for there to be inflation there has to be a greater increase to money supply relative to the supply of goods and services. If they are matched there is no inflation.

In order for there to be an increase in money supply there must be a banker willing to lend and a borrower willing to borrow. I think the emphasis by many Austrians is on idiotic bankers where I would like to see more of an emphasis on idiotic borrowers. In a speculative economy which does not produce things but rather relies on nominal asset appreciation, those with the first claim on freshly printed money will be the greatest beneficiaries, however in a productive economy this may not be so. Suppose A is in receipt of de novo central bank finance and uses the funds to make widgets. A gets first claim on a community’s goods and drives up prices, decreasing the purchasing power of B. However A’s widget making business is successful and the price of widgets decreases, B’s purchasing power has suddenly increased. If A’s business goes bust, the money created is essentially destroyed and the purchasing power of B remains intact.
As I see it printing money for good ideas is a good idea, provided it provides a benefit for the consumer and is allowed to go bust if it doesn’t. The problem is that it is very hard for a business to go bust, especially if it is a really big business with political clout.

If A is going under—because no one wants the widgets he is making– and the central bank tries to keep him afloat by lending him more de novo money it is true that A can claim more services weakening B’s purchasing power pushing up inflation. Indeed the more “help” a gets the worse B purchasing power becomes. Trying to help A actually maintains the misallocated capital structure while at the same time driving up inflation.
This is why I’m against “inflating” our way out of our current problem. The savers get screwed there reckless get their necks saved and the bad capital allocation structure remains intact. However good businesses get screwed when fear overwhelms bankers and liquidity dries up.

In order for capitalism to work effectively there has to be the possibility of failure and consequences. Reckless and predatory lenders should be put in jail: for a long time. Fraud should be punished severely. Efforts must be made to repay debts. There must be negative consequences for loosing money, particularly other peoples. On the other hand prudent investment and thrift must be rewarded as they are the bedrock of capitalism. The undermining of debt through inflation is an attack of capitalism at its core.

Even Keynes did not advocate this line of thinking. He argued that the deficit accumulated during a deficit spending spree by the Government should be paid back once the economy got going. I don’t think he ever argued for a debasement of the currency.

The reality is that as a result of poor government, bad economic policies, Australians made short term rational but long term disastrous decisions with their finances. They were quite happy to keep the spoils of their luck but will predictably now demand that other be forced to bale them out of their misjudgment in the name of community solidarity. I think there are ways out of the impending crisis but currency debasement is not one of them. I think the most humane way of dealing with the impeding debt disaster is to allow bad “investments” to go to the wall, taxing the recent windfalls in property and using the proceeds to stimulate productive investment in the country. Politically that ain’t gonna happen in the current climate.

> “I personally don’t think money supply is the problem; money allocation is. ”

When money and credit increases (monetary inflation), it is outside the control of central banks on where it goes. It could go to property or stocks or gold or commodities or food. Furthermore, when the money and credit supply is inflated, it will be inevitable that different people will receive the newly ‘printed’ money at different times. Those at the ‘furthest’ locale (e.g. priest) of the economy will receive the newly ‘printed’ money last, which by then will be deprived because prices had already risen. Those in the front of the queue (e.g. investment bankers) to receive such money benefit most because they’re the first one to spend them.

Therefore, debasement of money will inevitably result in re-distribution of wealth to the detriment of society. This is because the benefits does not go to the ones who works the hardest to serve society- rather, it goes to the ones who can elbow their way to the front of the queue to receive the newly ‘printed’ money.

That’s why in times of monetary inflation, you can see people investment bankers, hedge funds, CEOs, speculators getting obscenely rich very quickly, while other truly smart people like doctors, engineers, scientists lagging far behind as they battle price inflation. That’s why we see the proliferation of stock brokerage accounts (e.g. CFDs) as this is a symptom of people pushing their way to the front of the money queue as it is far more profitable to speculate in stocks then work hard for it.

Firstly, I agree that the figure of 500 billion is way too big for the Australian economy. It was used mainly for illustrative purposes.

Secondly, I also agree that it is the private banks that actually generate the fiat money in the financial system but I also think the both Government and the Reserve bank influence the extent of the fiat money creation. The government by regulating the amount the banks must keep in reserve for depositors and the Reserve by influencing the interest rate. The Government could influence the creation of private fiat money by increasing the fractional reserve the private banks have to maintain.

I personally don’t think money supply is the problem; money allocation is. I get offers for loans and lines of credit all the time. I don’t take them because I know I will get into financial trouble if I do. I live within my means, many people don’t. Why should I have to pay for their ill judgment at best and greed at worst?

My concern with inflation is that the main victims of it would be superannuants who may have had nothing to do with Ponzi sheme. Sure, people who made money on housing early on would loose as a result of inflation but so would the retirees and current contributors to superannuation who would effectively see their savings eroded. At the same time those who recklessly, ignorantly or stupidly borrowed beyond their means would be given a lifeline. Culturally it is the punishment of thrift and the reward of extravagance: The “inflation solution” is a moral hazard which plays a large part in the formation of these Ponzi schemes. When people know that the Government will always back them out of a stupid financial position, they will become more reckless as time goes on. The “inflation solution” is intrinsic to cyclical bubble formation.

I could be wrong here but I understand that Japan tried one of the biggest deficit spending programs in the world in an attempt to stimulate its economy without effect. I think failure to stimulate the economy was due to both the capital structure of the Japanese economy and the cultural peculiarities of the Japanese. Given more money they didn’t want to spend: They saved. Deficit spending by the Australian Government would probably worsen our balance sheets due to the peculiar capital and cultural structure of our country. We would get a temporary fix but it would probably push us further in the hole.

The other massive problem is the demographic peculiarity of our time. If we destroy the savings of retirees, who is going to pay for them? With theoretically 30+ years of retirement (during which time they are net consumers) they are going to require lot of money. Wiping away their savings simply means that we are going to have to increase taxes in order to support them. Whether this is an appropriate system of wealth distribution I don’t know. But I don’t think it is going to be conducive to productive investment in the future.

Once again, my comments are given with the greatest respect. By the way, have you heard of Peter Brain? He has been talking about our economic problems for years now.