Central Banks Double Down on the Failed Policies of the Twentieth Century

In a macroeconomics-driven world, economic fallacies abound. They are periodically trashed when disproved, only to arise again as received wisdom for a new generation of macroeconomists determined to justify their statist beliefs. The most egregious of these is that inflation can only occur as the handmaiden of economic growth, while deflation is similarly linked to a recession spinning out of control into the maelstrom of a slump.

This error is the opposite of the facts.

Conventionally, macroeconomists split into two groups. There are the Keynesians who believe in stimulating demand to ensure there will always be markets for goods and services, which they attempt to achieve through additional spending by governments and by discouraging saving, because it is consumption deferred. And there are the supply-siders, who believe in stimulating production through lower corporate taxes and lighter regulation. Both demand and supply-siders advocate monetary inflation in the belief that their methods stimulate an economy so that government spending need not be cut.

The maintenance of government spending is the objective of both approaches, not the welfare of economic actors, who are always regarded as the state’s milch cows. While supply-side reforms have proved more attractive to free traders than Keynesian demand stimulus, the end result is the same: the combination of taxes and monetary seigniorage from the productive economy transferred to the state is the objective either way.

Economic Growth Is Not the Same as Economic Progress

The smoke and mirrors to get people to part with their wealth are the misuse of statistics. The price consequences of monetary inflation are suppressed by statistical method, and economic growth is substituted for economic progress, the combination leading to confusion for nearly all economists. But the facts behind the measure of growth, gross domestic product, are easily explained.

First, the modelling assumptions. As a starting point we must assume there is no inflation of money and credit and the quantity of money is fixed. That being the case, and assuming no change in the statistical makeup of GDP, nor in the quantity of hoarded cash, and assuming no change in the balance of external trade, there can be no increase in nominal GDP, because whatever people make, sell and consume amounts to the same total expressed in money terms compared with the previous period. It is an accounting identity. Whether savings increase or decrease is immaterial, because GDP is the total of final goods and intermediate goods, so if an economy evolves from being consumer to savings driven or vice versa, GDP must remain unchanged. The split between profit and costs is immaterial as well, the sum of the two being contained within the GDP total. But variations in the rate of economic progress will always be reflected in the individual prices and quantities of goods and services produced without the total monetary value of all transactions changing. A progressive economy will see more and better goods and services at lower prices, while for a failing economy the opposite is be true.

The next step should not be beyond the understanding of anyone. If a fairy godmother magically created some extra money for the people in an economy to spend, it must simply be added to the GDP total, whether they spend it or save it—as long as they don’t hoard it. Saving circulates, because it is money made available for investment. Hoarding is taking money out of circulation, which is why in our model we must assume the quantity of money hoarded does not change.

Macroeconomists confuse the additional money injected into the economy with growth. It is growth in the money total only, because it is impossible to judge the degree to which it is used to economic advantage. Economic growth has become confused with economic progress.

Economists today appear unaware of this distinction, which Ludwig von Mises separated out into what he called an evenly rotating economy. He defined it as follows:

An imaginary economy in which all transactions and physical conditions are repeated without change in each similar cycle of time. Everything is imagined to continue exactly as before, including all human ideas and goals. Under such fictitious constant repetitive conditions there can be no net change in any supply of demand and therefore there cannot be any change in prices.

The inconvenient truth for statists is that with GDP they can only measure the quantity of money in total transactions, not how it is used. This fits von Mises’s description of an imaginary economy that evenly rotates and it is vital for any student of economics to understand this point. It matters not whether he or she is a demand- or supply-sider; both categories of macroeconomic emphasis wrongly believe in targets for GDP outcomes, which are meaningless except for the purpose of maintaining government revenue. And that is the key to their interest.

It is with this perspective that we must understand the role of monetary inflation in an economy, and the reason for underlying, statist-driven beliefs that inflation is good, and deflation is bad. For the state the absence of monetary inflation is a loss of a growing and important source of revenue at a time of escalating welfare and other costs.

In This Time of Crisis, We Need Deflation, Not Inflation

Coronavirus shutdowns have thrown the problems facing government finances into sharp relief. Keynesians are yet again losing the practical argument as all nations see government finances spinning out of control. Instead, the policies behind governments’ finances have been forced to drift into a default version of supply-side economics to help businesses survive. Taxes on businesses have been deferred or cut, employment subsidised, and the rich left alone. If anything, the rich are being subsidised through asset price inflation, which is the initial consequence of accelerating monetary inflation.

Whether it is demand or supply being manipulated, the one objective behind it all is the satisfaction of government finances over the business cycle.

Now that hopefully we have put the GDP fallacy in its proper context, we are in a better position to understand why, contrary to modern economic doctrines, the natural state for an economy that progresses is not one that sees continual and planned inflation, which are monetary policy objectives, but gradually falling prices. This was the experience under the gold standard of the nineteenth century and is easily explained: within a confined money total such as that of monetary gold, an increase in the quantity of goods and services taking place can only be accommodated by a decline in the general level of prices. Put another way, the purchasing power of sound money, a money whose quantity is not inflated, always rises over time.

Not that the quantity of gold and gold substitutes was ever fixed. In the nineteenth century, the quantity of monetary gold was inflated by new discoveries in California, Australia and South Africa, and we must also mention the fluctuations in bank credit which masqueraded as gold substitutes. But the expansion in the money quantity was insufficient to prevent the general level of prices falling over time between the introduction of the gold standard in Britain in 1821 and the First World War. And it should go without saying that it was this period that saw the bulk of the British population move from bare subsistence living to immensely improved conditions.

Today’s macroeconomic beliefs defy all the historical evidence with its focus on increasing the economic presence of the state at the expense of the productive private sector. Free markets and sound money benefit savers and workers by increasing the purchasing power of their savings and wages over time. They encourage the accumulation of personal wealth. They displace the speculation predominant in financial assets today. They discourage profligacy, indolence and needless borrowing. With the exception of the destitute and others who can be more effectively supported by voluntary institutions, they allow the vast majority of people to provide for their own personal health and retirement, freeing their governments from onerous welfare obligations.

In other words, the mild but continuous deflation of prices, which is the principal feature of sound money, removes a financial burden from the state, leaving it with minimal negative economic impact. And the smaller the government is, the less its tax depredations are on economic actors and the more effectively the free market economy becomes in improving standards of living for all.

By comparison, today’s unsound money conditions are inherently destructive. Monetary inflation indiscriminately robs both savers and wage earners. Not only is the accumulation of personal wealth by the masses taxed away or discouraged, speculation in financial assets is encouraged in order to create a replacement wealth effect. Profligacy, indolence and needless borrowing are hallmarks of the inflationary regime. Companies lobby for subsidies and for government protection from competition by creating anticompetitive regulatory burdens to discourage upstart innovators. Nearly everyone can freeload on state-provided welfare, the provision of health and mandated minimum wages. Government’s nonproductive burden on the economy inevitably grows to the point of economic strangulation.

It follows that the progressive wealth transfer from its citizens into the government’s hands through monetary inflation reduces not only the value of wealth left to be transferred but as noted above it becomes an increasing burden on the economy. Insofar as the government has mandated to itself future liabilities, in inflationary times those liabilities also rise in their estimated net present value making them unaffordable, even though it is naively claimed that inflation benefits government finances by reducing the value of its existing debt. The final outcome of inflationary financing is always the same: the destruction of the productive economy through increasing wealth transfer and therefore of the currency itself.

Due in part to the coronavirus, now that economies are visibly sliding into an economic abyss the end is in sight for macroeconomic fallacies. But in the coming months we will have to endure a doubling down of destructive monetary policies as Keynesians and supply siders battle it out over how to access and deploy the citizens’ remaining wealth.

The true scale of their mistakes will only be revealed in a final crisis and the end of fiat currencies.

Excerpted from Inflation, Deflation, and Other Fallacies