DEFLATION AND LIBERTY by Herg Guido Hulsman
Preface
It is my great pleasure to see this little essay in print, written and presented more than five years ago.
It was welcomed at the time by scholars with a background in Austrian economics.
However, it was not understood and was rejected by those who did not have this background.
In order to reach a broader audience, a short essay would simply not do.
I therefore decided not to publish Deflation in Liberty and started to work on The Ethics of Money Production,
a book-length presentation of the argument, which has just become available from the Mises Institute.
In the present crisis, the citizens of the United States have to make an important choice.
They can support a policy designed to perpetuate our current fiat money system and the sorry state of banking and of financial markets that it logically entails.
Or they can support a policy designed to reintroduce a free market in money and finance.
This latter policy requires the government to keep its hands off.
It should not produce money, nor should it appoint a special agency to produce money. It should not force the citizens to use fiat money by imposing legal tender laws. It should not regulate banking and should not regulate the financial markets. It should not try to fix the interest rate, the prices of financial titles or commodity prices.
Clearly, these measures are radical by present-day standards and they are not likely to find
sufficient support, but they lack support out of ignorance and fear.
We are told by virtually all the experts on money and finance, the central bankers and
most university professors, that the crisis hits us despite the best efforts of the Fed.
That money, banking and financial markets are not meant to be free because they end
up in disarray despite the massive presence of the government as a financial agent, as
a regulator and as money producer.
That our monetary system provides us with great benefits that we would be foolish not
to preserve.
Those same experts therefore urge us to give the government an even greater presence in
in the Financial Markets to increase its regulatory powers and to encourage even more money production
to be used for bailouts. However, all of these contentions are wrong, as economists have demonstrated
again and again since the times of Adam Smith and David Ricardo. A paper money system is
not beneficial from an overall point of view. It does not create real resources on which
Which our welfare depends, it merely distributes the existing resources in a different manner.
Some people gain, others lose. It is a system that makes banks and financial markets vulnerable
because it induces them to economize on the essential safety valves of business, cash
and equity. Why hold any substantial cash balances if the central bank stands ready
Why use your own money if you can finance your investments with cheap credit from the printing press?
To raise these questions is to answer them.
The crisis did not hit us despite the presence of our monetary and financial authorities, it hit us because of them.
Then there is the fear factor. If we follow a hands-off policy, the majority of experts tell us the banking industry, the financial markets and much of the rest of the economy will be wiped out in a bottomless deflationary spiral.
The present essay argues that this is a half-truth. It is true that without further government intervention there would be a deflationary spiral.
It is not true that this spiral would be bottomless and wipe out the economy. It would not be a mortal threat to the lives and the welfare of the general population. It destroys essentially those companies and industries that live a parasitical existence at the expense of the rest of the economy and which owe their existence to our present fiat money system.
Even in the short run, therefore, deflation reduces our real incomes only within rather narrow limits.
And it will clear the ground for very substantial growth rates in the medium and long run.
We should not be afraid of deflation. We should love it as much as our liberties.
1. The 20th century has been the century of omnipotent government. In some countries totalitarian
governments have established themselves in one stroke through revolutions, apparently
a bad strategy, for none of these governments exist anymore. But in other countries totalitarianism
has not sprung into life full-fledged like Venus from the waves. In the United States
and in virtually all the Western European countries, government has grown slowly but
steadily, and if unchecked, this growth will make it totalitarian one day, even though
this day seems to be far removed from our present. Fact is that in all Western countries,
The growth of government has been faster over the last 100 years than the growth of the
economy. Its most conspicuous manifestations are the welfare state and the warfare state.
In the American case, the warfare state has been a more powerful engine of government
growth than the welfare state. Now the growth of the welfare-warfare state would not have
have been possible without inflation, which for the purposes of our study, we can define
as the growth of the supply of base money and of financial titles that are redeemable
into base money on demand.
With this definition, we follow Murray and Rothbard, who defines inflation as an increase
of the quantity of money greater than an increase in specie.
While Rothbard's definition fits the case of a fractional reserve banking system based
on a commodity money standard, our definition is meant to fit the specific case of a fiat
money standard with fractional reserve banking.
Both definitions deviate from the most widespread connotation of the term according to which
inflation is an increase of the money price level.
The latter definition is not very useful for our purposes, because we intend to analyze
the causal impact of changes in the supply of base money, which is at all times subject
to political control.
The production of ever new quantities of paper dollars and the creation of ever new credit
facilities at the Federal Reserve have provided the liquidity for an even greater expansion
Expansion of Bank-Created Demand Deposits and Other Money Substitutes, which in turn
allowed for an unparalleled expansion of public debt. U.S. public debt is currently, December
2002, at some $6.2 trillion, up from under $2 trillion at the beginning of the 1980s
and less than $1 trillion before the era of the paper dollar set in when President Nixon
closed to the gold window in the early 1970s.
The link between the paper dollar and the exponential expansion of public debt is well
known.
From the point of view of the creditors, the Federal Government controls the Federal Reserve,
the monopoly producer of paper dollars, and it can therefore never go bankrupt.
If necessary, the Federal Government can have any quantity of dollars printed to pay back
The Federal Government can constantly expand its activities and finance them through additional debt, even if there is no prospect at all that these debts will ever be paid back out of tax revenues.
The result is seemingly unchecked growth of those governments that control the production of paper money.
Among the many causes that coincided in bringing about this state of affairs is a certain lack of resistance on the part of professional economists.
In the present essay, I will deal with a wrong idea that has prevented many economists and other intellectuals from fighting inflation with the necessary determination.
Most economists backed off from opposing inflation precisely when it was needed most, namely at the few junctures of history when the inflationary system was about to collapse.
Rather than impartially analyzing the event, they started fearing deflation more than inflation and thus ended up supporting reflation, which in fact is nothing but further inflation.
For the purposes of our study, we will define deflation as a reduction of the quantity of base money, or of financial titles that are redeemable into base money on demand.
Again, this deviates from the usual connotation of the term which defines deflation as a decrease of the price level.
level. But as the reader will see, our analysis will cover both phenomena, deflation in our
definition and decrease of the price level. The point of our definition is merely to render
our analysis more suitable for practical application. A monetary authority at all times can prevent
deflation in our definition, while it can at times be unable to prevent a decrease of
of the price level, even by pumping great quantities of base money into the economy.
The United States of America has experienced two such junctures, the years of the Great
Depression and the little depression we are facing right now in the wake of the first
global stock market boom. Today again, the deflationary collapse of our monetary system
is a very real possibility. In November 2002, officials of the Federal Reserve, Greenspan,
Bernanke and of the Bank of England, BEAN, proclaimed there would be no limit to the
amount of money they would print to fend off deflation. These plans reflect what today is
widely regarded as orthodoxy in monetary matters. Even many critics of the inflationary policies
To finance the increased spending, the governments should incur more debts, and that the central
banks should print more money. See, for example, the columns and editorials by journalists
with a hard money reputation, such as Steve Forbes in the U.S. and Stephan Barron in Germany.
The same message emanates from the publications of otherwise reasonable economists, such as
Jude Woniski and Norbert Walter. Such views have a certain prominence even among Austrian
economists. Ludwig von Mises, Hans Sennholz, Murray Rothbard and other Austrians are known
for their intransigent opposition to inflation. But only Sennholz did not flinch from praising
deflation and depression when it came to abolishing fiat money and putting a sound money system
in its place. By contrast, Mises and Rothbard championed deflation only to the extent it
accelerated the readjustment of the economy in a bust that followed a period of inflationary
boom. But they explicitly, Mises, and implicitly, Rothbard, sought to avoid deflation in all
and other context. In particular, when it came to monetary reform, both Mises and Rothbard
championed schemes to redefine a paper currency's price of gold to restore convertibility.
The main weakness of this scheme is that it implies that the reform process be directed
by the very institutions and persons whom the reform is supposed to make more or less
It is also questionable whether our monetary authorities can legitimately use their gold reserves to salvage their paper money.
In fact, they have come to control these reserves through a confiscatory coup, and it is therefore not at all clear how plans for monetary reform,
The monetary reform a la Mises and Rothbard can be squared with the libertarian legal or moral principles that Rothbard champions in other works.
But there is also another issue that needs to be addressed.
What is actually wrong with deflating the money supply from an economic point of view?
This question will be at center stage here, which can fortunately build on Rothbard's analysis of deflation,
which demonstrated in particular the beneficial role that deflation can have in speeding up
the readjustment of the productive structure after a financial crisis.
But no economist seems to have been interested in further pursuing the sober analysis of
the impact of deflation on the market process and of its social and political consequences.
The truth is that deflation has become the scapegoat of the economics profession. It
is not analyzed, but derided. One hundred years of pro-inflation propaganda have created
a quasi-total agreement on the issue. The main engines of the propaganda have been the
state universities of the West, as well as an exaggerated faith in the authority of monetary
Experts in the service of the IMF, the World Bank, the Federal Reserve and other government
agencies charged with the technical details of spreading inflation.
Is it really necessary to point out the non sequitur implied in granting expert status
in matters monetary to the employees of these organizations?
An obvious parallel is the case of the economist on the payroll of labor unions who, because
labor unions pay them, are considered to be experts in labor economics. Clearly, if one
called labor unions associations for the destruction of the labor market, which most of them are
by any objective standard, the expertise of their employees would stand in a more sober
The same thing holds true for those writers on monetary affairs who happen to be on the payroll of the various associations for the destruction of our money.
This is, of course, not to deny that there might be good economists working for the IMF or the Federal Reserve.
Our point is merely that their qualification to speak on the issue is not at all enhanced by their professional affiliation.
Deflation. Quite to the contrary, given the incentive structure, we would have to expect
that good monetary economists only accidentally find their way to these institutions.
Wherever we turn, deflation is uniformly presented in bad terms, and each writer hurries to present
the fight against deflation as the bare minimum of economic statesmanship. Economists who otherwise
Students who cannot agree on any subject are happy to find common ground in the heartfelt
condemnation of deflation. In their eyes, the case against deflation is so clear that
they do not even bother about it. The libraries of our universities contain hundreds of books
splitting hairs about unemployment, business cycles and so on, but they rarely feature
a monograph on deflation. Its evilness is beyond dispute.
The outstanding modern theoretician of deflation is Murray N. Rothbard. As we have stated
above, Rothbard's views on deflation seem to be deficient only when it comes to the
practical issue of monetary reform. Yet this silent accord stands on shaky ground. A frank
and enthusiastic endorsement of deflation is, at any rate in our time, one of the most
2. When it comes to matters of money and banking, all practical political issues ultimately
hinge on one central question. Can one improve or deteriorate the state of an economy by
increasing or decreasing the quantity of money? Speaking of an economy, we mean the group
Aristotle said that money was no part of the wealth of a nation, because it was simply
is a medium of exchange in interregional trade, and the authority of his opinion thoroughly marked medieval thought on money.
Scholastic scholars, therefore, spent no time inquiring about the benefits that changes of the money supply could have for the economy.
The relevant issue in their eyes was the legitimacy of debasements, because they saw that this
was an important issue of distributive justice.
And after the birth of economic science in the 18th century, the classical economist
who did not deny this essential point, David Hume, Adam Smith, and Etienne de Condelac
observed that money is neither consumers' good nor producers' good, and that, therefore,
its quantity is irrelevant for the wealth of a nation.
This crucial insight would also inspire the intellectual battles of the next four or five
generations of economists, men such as Jean-Baptiste Say, David Ricardo, John Stuart Mill, Frederic
Bastiat and Carl Menger, who constantly made the case for sound money. As a result, the
western world had much more sound money in the 19th century than in the 20th century.
Large strata of the population paid and were paid in coins made out of precious metals,
especially out of gold and silver. It was money that made these citizens, however humble
all their social status sovereign in monetary affairs, the art of coinage flourished and
produced coins that could be authenticated by every market participant.
Some present-day libertarians harbor a romantic picture of these days of the classical gold
standard, and it is true that it was the golden age of monetary institutions in the West,
especially when we compare them with our own time, in which the monetary equivalent of
alchemy has risen to the status of orthodoxy.
But it is also true that Western monetary institutions in the era of the classical gold standard
were far from being perfect.
Governments still enjoyed monopoly power in the field of coinage, a remnant of the medieval
regalia privileges that prevented the discovery of better coins in coin systems through entrepreneurial
competition.
They actively promoted fractional reserve banking, which promised ever new funds for the public treasury, and they promoted the emergence of central banking through special monopoly charters for a few privileged banks.
The overall result of these laws was to facilitate the introduction of inflationary paper currencies and to drive specie out of circulation.
At the beginning of the 19th century, most of Europe, insofar as it knew monetary exchange at all, used paper currencies.
At the time, John Wheatley observed, in England, Scotland and Ireland, in Denmark and in Austria, scarcely anything but paper is visible.
And during the remainder of that century, things did not change much. England alone among the major nations was on the gold standard during the greater part of the 19th century, and banknotes of the Bank of England played an important role in the development of the world.
played a much greater role in monetary exchanges than specie. In fact, the reserve ratio of
the bank seems to have been around 3% for most of the time, and occasionally it was
even lower. Jacob Weiner emphasizes that the pre-World War I gold standard was not fundamentally
different from the interwar gold exchange standard. It was a managed standard. This
This attenuates the thesis of Jacques Rouff that the gold exchange standard introduced
something like a quantum leap deterioration into the international monetary system.
In short, the monetary constitutions of the 19th century were not perfect and neither
would the monetary thought of the classical economist satisfy us today. David Hume believed
that inflation could stimulate production in the short run, Adam Smith believed that
inflation in the form of credit expansion was beneficial if it was backed up with a
corresponding amount of real goods, and Jean-Baptiste Say similarly endorsed expansions of the quantity
of money that accommodated the needs of commerce. Smith and Ricardo suggested increasing the
The Wealth of the Nation by substituting inherently valueless paper tickets for metallic money.
John Stuart Mill championed the notion that sound money means money of stable value.
These errors in the monetary thought of Hume, Smith, Ricardo and Mill were, of course, almost
negligible in comparison to their central insight, to repeat, that the wealth of a nation
does not depend on changes in the quantity of money.
But eventually a new generation of students infected with the virus of statism, worship
of the state, rushed over that central insight and thus the errors of the classical economist
rather than their science triumphed in the 20th century.
Men such as Irving Fischer, Newt Wixel, Carl Helfrich, Friedrich Bendixson, Gustav Kassel
and especially John Maynard Keynes set out on a relentless campaign against the gold standard.
These champions of inflation conceded the insight of the classical economist that the
wealth of a nation did not depend on its money supply.
But they argued that this was true only in the long run.
In the short run, the printing press could work wonders, it could reduce unemployment
and stimulate production and economic growth.
Who could reject such a horn of plenty and why?
Most economists point out the cost of inflation in terms of loss of purchasing power.
Estimates run as high as a 98% reduction of the U.S. dollar's purchasing power since the
Federal Reserve took control of the money supply.
What is less well known are the concomitant effects of the century-long great dollar inflation.
Paper money has produced several great crises, each of which turned out to be more severe
than the preceding one.
Moreover, paper money has completely transformed the financial structure of the Western economies.
At the beginning of the 20th century, most firms and industrial corporations were financed
out of their revenues and banks and other financial intermediaries played only a subordinate
role.
Today, the picture has been reversed and the most fundamental reason for this reversal
is paper money.
Paper money has caused an unprecedented increase of debt on all levels, government, corporate
and individual.
It has financed the growth of the state on all levels, federal, state and local.
It thus has become the technical foundation for the totalitarian menace of our days.
In the light of these long-term consequences of inflation, its alleged short-run benefits
lose much of their attractiveness, but the great irony is that even these short-run benefits
in terms of employment and growth are illusory. Sober reflection shows that there are no
systematic short-run benefits of inflation at all. In other words, whatever benefits
might result from inflation are largely the accidental result of inflation hitting a particularly
favorable set of circumstances, and we have no reason to assume that these accidental
Short-run benefits are more likely to occur than accidental harm, quite to the contrary.
The main impact of inflation is to bring about a redistribution of resources.
There are therefore short-run benefits for certain members of society, but these benefits
balanced by short-run losses for other citizens.
The great French economist, Frederic Bastiat, made the quite general point that the visible
All blessings that result from government intervention into the market economy are in fact only one
set of consequences that follow from this intervention.
But there is another set of consequences that the government does not like to talk about
because they demonstrate the futility of the intervention.
When the government taxes its citizens to give subsidies to a steel producer, the benefits
Interest to the steel firm, its employees and stockholders are patent, but other interests
have suffered from the intervention.
In particular, the taxpayers have less money to patronize other businesses, and these other
businesses and their customers are also harmed by the policy because the steel firm is now
and so it is with inflation. There is absolutely no reason why an increase in the quantity of money should create more rather than less growth. It is true that the firms who receive money fresh from the printing press are thereby benefitted.
But other firms are harmed by the very same fact because they can no longer pay the higher prices for wages and rents that the privileged firm can now pay.
And all other owners of money, whether they are entrepreneurs or workers, are harmed too because their money now has a lower purchasing power than it would otherwise have had.
Similarly, there is no reason why inflation should ever reduce, rather than increase, unemployment.
People become unemployed or remain unemployed when they do not wish to work,
or if they are forcibly prevented from working for the wage rate an employer is willing to pay.
Inflation does not change this fact.
What inflation does is to reduce the purchasing power of each money unit. If the workers anticipate these effects, they will ask for higher nominal wages as a compensation for the loss of purchasing power. In this case, inflation has no effect on unemployment, quite to the contrary, it can even have negative effects, namely if the workers overestimate the inflation-induced reduction of the purchasing power of each money unit.
All plans to reduce unemployment through inflation, therefore, boil down to fooling the workers, a childish strategy, to say the least.
The long-standing presence of mass unemployment in Germany, France, and other European countries
seems to be a smashing refutation of the Keynesian hypothesis.
If anything, the labor unions in these countries clearly seem to overestimate the inflation rate.
For the same reason, inflation is no remedy for the problem of sticky wages,
that is, for the problem of coercive labor unions.
Wages are sticky only to the extent that the workers choose not to work.
But the crucial question is, how long can they afford not to work?
And the answer to this question is that this period is constrained within the very narrow limits of their savings.
As soon as a worker's personal savings are exhausted, he willy-nilly starts offering his services even at lower wage rates.
It follows that in a free labor market, wages are sufficiently flexible at any point of time.
Stickiness comes into play only as a result of government intervention, in particular in the form of
a. tax-financed unemployment relief and of
b. legislation giving the labor unions a monopoly of the labor supply.
Since we are not concerned here with questions of labor economics,
We can directly turn to the connection between employment and monetary policy.
Does inflation solve the problem of sticky wages?
The answer is in the negative.
And for the same reasons we pointed out above,
inflation can overcome the problem of sticky wages only
to the extent that the paper money producers can surprise the labor unions.
To the extent that the latter anticipate the moves of the masters of the printing press, inflation will either not reduce unemployment at all or even increase it further.
3. From the standpoint of the commonly shared interest of all members of society, the quantity of money is irrelevant.
Any quantity of money provides all the services that indirect exchange can possibly provide, both in the long run and in the short run.
This fact is the unshakable starting point for any sound reflection on monetary matters.
And it is the most important criterion when it comes to dealing with deflation.
In light of the principle discovered by the classical economist, we can say that deflation is certainly not what it is commonly alleged to be, a curse for all members of society.
Deflation is a monetary phenomenon and, as such, it does affect the distribution of wealth among the individuals and various strata of society, as well as the relative importance of the different branches of industry, but it does not affect the aggregate wealth of society.
Deflation is a drastic reduction of the quantity of money or of money substitutes, and it entails a precipitous decline of money prices. Such an event, be it ever so dramatic for a great number of individuals, is most certainly not a mortal threat for society as a whole.
This is also recognized, implicitly at least, in the few works of management literature that deal with entrepreneurship in a deflationary environment.
Imagine if all prices were to drop tomorrow by 50 percent.
Would this affect our ability to feed, clothe, shelter and transport ourselves?
It would not, because the disappearance of money is not paralleled by a disappearance of the physical structure of production.
In a very dramatic deflation, there is much less money around than there used to be, and thus we cannot sell our products and services at the same money prices as before.
But our tools, our machines, the streets, the cars and trucks, our crops and our food supplies, all this is still in place, and thus we can go on producing, and even producing profitably, because profit does not depend on the level of money prices at which we sell, but on the difference between the prices at which we sell and the prices at which we buy.
In a deflation, both sets of prices drop and, as a consequence, for-profit production can go on.
There is only one fundamental change that deflation brings about.
It radically modifies the structure of ownership.
Firms financed per credits go bankrupt because at the lower level of prices,
is that they can no longer pay back the credits they had incurred without anticipating the deflation.
Private households with mortgages and other considerable debts to pay back go bankrupt
because with the decline of money prices their monetary income declines too,
whereas their debts remain at the nominal level.
The very attempt to liquidate assets to pay back debt entails a further reduction of the value of those assets, thus making it even more difficult for them to come even with their creditors.
In the memorable words of Irving Fisher, the more the debtors pay, the more they owe.
Yet from this correct observation, Fisher jumped to the fallacious statement that the liquidation defeats itself.
Let us emphasize again that bankruptcies, irrespective of how many individuals are involved, do not
affect the real wealth of the nation, and in particular that they do not prevent the
successful continuation of production.
The point is that other people will run the firms and own the houses, people who at the
time the deflation set in were out of debt and had cash in their hands to buy firms and
These new owners can run the firms profitably at the much lower level of selling prices because they bought the stock and will buy other factors of production at lower prices too.
In short, the true crux of deflation is that it does not hide the redistribution going hand in hand with changes in the quantity of money.
It entails visible misery for many people to the benefit of equally visible winners.
This starkly contrasts with inflation, which creates anonymous winners at the expense of anonymous losers.
Both deflation and inflation are, from the point of view we have so far espoused, zero-sum games.
But inflation is a secret rip-off, and thus the perfect vehicle for the exploitation of a population through its false elites.
Whereas deflation means open redistribution through bankruptcy according to the law.
4. With these statements we could close our analysis. We have seen that deflation is not inherently bad and that it is therefore far from being obvious that a wise monetary policy should seek to prevent it or dampen its effects at any price.
Deflation creates a great number of losers, and many of these losers are perfectly innocent people who have just not been wise enough to anticipate the event.
But deflation also creates many winners, and it also punishes many political entrepreneurs who had thrived on their intimate connections to those who control the production of fiat money.
Deflation is certainly not some sort of a reversal of a previous inflation that repairs the harm done in prior redistributions.
It brings about a new round of redistribution that adds to the previous round of inflation-induced redistribution.
But it would be an error to infer from this fact that a deflation following a foregoing inflation was somehow harmful from an economic point.
Because it would involve additional redistributions.
The point is that any monetary policy has redistributive effects.
In particular, once a deflation of the supply of money substitutes sets in,
the only way to combat this is through inflation of the supply of base money.
And this policy, too, involves redistribution and thus creates winners and losers.
It follows that there is no economic rationale for monetary policy to take up an ardent fight against deflation, rather than letting deflation run its course.
Either policy does not benefit the nation as a whole, but merely benefits a part of the nation at the expense of other groups.
No civil servant can loyally serve all of his fellow citizens through a hard-nosed stance
against deflation, and neither can he invoke the authority of economic science to buttress
such a policy.
But there is also another point of view that merits consideration and which is in fact
decisive for our problem.
It results from the fact that in practice there are at any point in time two, and only
There are only two fundamental options for monetary policy.
The first option is to increase the quantity of paper money.
The second option is not to increase the paper money supply.
Now the question is how well each of these options harmonizes with the basic principles on which a free society is built.
5. How would money be produced in a free society? Let us first observe that the fact that the quantity of money is irrelevant for the wealth of a nation must not be confused with the ideal of stabilizing the quantity of money.
The latter ideal is in fact a spurious ideal and does not follow from the aforementioned fact.
There is nothing wrong with increases or decreases of the quantity of money.
The point is that such increases or decreases should not be mistaken to benefit society as a whole.
Right and wrong in monetary policy does not concern the question,
To which end should the quantity of money be modified?
Rather, it concerns the question, who has the right to modify the quantity of money?
And in a free society, the obvious answer is, all producers of money have the right to produce more money,
and all owners of money have the right to use their property as they see fit.
In a truly free society, the production of money is a matter of private initiative. Money is produced and sold just as any other commodity or service. And this means, in particular, that in a free society the production of money is competitive.
It is a matter of mining precious metals and of minting coins, and both mining and minting
are subject to the competition emanating from all other market participants.
In selling his product, the money producer competes with all other people who own money
and seek to buy the same goods that he desires.
And in buying factors of production, the money producer competes with the producers of chairs,
theatre performances, telephones, carpets, cars, and so on.
In a word, in a free society the production of money is constrained within fairly narrow
limits, limits that are determined by the willingness of other members of society to
cooperate with our money producer rather than with someone else.
What kind of money would prevail in a free society?
All considerations and historical experience all point to the same answer. A free society would use precious metals as money. Payments would be made in coins made out of gold, silver, platinum, copper, or whatever other substance would combine scarcity with the physical advantages of these metals.
By contrast, paper money has always been fiat money. That is, it has always been imposed by the coercive power of the state. It is not the money of the free market, but the money of a partially enslaved society.
6. The production of money in a free society is a matter of free association. Everybody
from the miners to the owners of the mines to the minters and up to the customers who
buy the minted coins, all of them benefit from the production of money. None of them
violates the property rights of anybody else because everybody is free to enter the mining
in Minting Business, and nobody is obliged to buy the product.
Things are completely different once returned to money production in interventionist regimes
which have prevailed in the West for the better part of the past 150 years.
Here we need to mention in particular two institutional forms of monetary interventionism,
fraudulent, fractional reserve banking and fiat money.
The common characteristic of both these institutions is that they violate the principle of free association.
They enable the producers of paper money and of money titles to expand their production through the violation of other people's property rights.
Banking is fraudulent whenever bankers sell uncovered or only partially covered money substitutes that they present as fully covered titles for money.
These bankers sell more money substitutes than they could have sold if they had taken care to keep a 100% reserve for each substitute they issued.
This point is, by the way, undisputed by all participants in the present debate on fractional
reserve banking.
In contrast to the present author, however, Lawrence White seems to believe that historical
fractional reserve banking has rarely, if ever, been fraudulent.
The producer of fiat money, in our days typically paper money, sells a product that cannot withstand
The competition of free market monies such as gold and silver coins and which the market participants only use because the use of all other monies is severely restricted or even outlawed.
The most eloquent illustration of this fact is that paper money in all countries has been protected through legal tender laws.
Laws. Paper money is inherently fiat money. It cannot thrive but when it is imposed by
the State. Notice that this point holds true only for genuine paper moneys, not necessarily
for national paper currencies consisting of money substitutes backed by commodity money.
Neither does our contention necessarily apply to credit moneys, such as the paper pound
during the Napoleonic Wars. In both cases, the production of money is excessive because
it is no longer constrained by the informed and voluntary association of the buying public.
On a free market, paper money could not sustain the competition of the far superior metal
monies. The production of any quantity of paper money is therefore excessive by the
The standards of a free society. Similarly, fractional reserve banking produces excessive
quantities of money substitutes at any rate in those cases in which the customers are
not informed that they are offered fractional reserve bank deposits rather than genuine
money titles. This excessive production of money and money titles is inflation by the
and the Rothbardian definition, which we have adapted in the present study to the case of paper money.
Inflation is an unjustifiable redistribution of income in favor of those who receive the new money and money titles first
and to the detriment of those who receive them last.
In practice the redistribution always works out in favor of the fiat money producers themselves
which we misleadingly call Central Banks and of their partners in the banking sector and at the stock exchange.
And of course inflation works out to the advantage of governments and their closest allies in the business world.
Inflation is the vehicle through which these individuals and groups enrich themselves unjustifiably at the expense of the citizenry at large.
If there is any truth to the socialist caricature of capitalism, an economic system that exploits the poor to the benefit of the rich, then this caricature holds true for a capitalist system strangulated by inflation.
The relentless influx of paper money makes the wealthy and powerful richer and more powerful than they would be if they depended exclusively on the voluntary support of their fellow citizens.
And because it shields the political and economic establishment of the country from the competition emanating from the rest of society, inflation puts a brake on social mobility.
The rich stay rich longer and the poor stay poor longer than they would in a free society.
In this regard, inflation works in an unholy alliance with the tax code.
The main advantage of the successful newcomer is that he has high revenues,
but present-day corporate and income tax rates effectively prevent him from accumulating capital quickly enough
to sustain the competition of the establishment.
As a result, there are virtually no more firms that make it from the very bottom into the major league of corporate capitalism.
It took a technological revolution to overcome these obstacles and bring a few firms such as Microsoft to the top of corporate America.
Most other firms are increasingly dependent on credit to finance any large-scale ventures.
But financial intermediation is today a highly regulated business.
And all major banks are already allied with the industrial establishment.
What would be their incentive to finance a venture that destroys the value of some of their other holdings?
A similar situation prevails in individual finance.
Consider just the most important case of private debt.
The result is that virtually nobody even thinks of financing a home the way it has been done in former times, namely, by first saving money and then paying for it.
Paying for the house in cash and paper money has made it possible to always provide new
credits for willing homeowners.
The printing press of the Federal Reserve has fueled a housing boom just as it has fueled
the 1990s boom of the stock market.
The stock market boom has already ended in a resounding crash.
The housing boom is next in line.
The famous economist Joseph Schumpeter once presented inflation as the harbinger of innovation.
As he had it, inflationary issues of banknotes would serve to finance upstart entrepreneurs
who had great ideas but lacked capital.
Now, even if we abstract from the questionable ethical character of this proposal, which
boils down to subsidizing any self-appointed innovator at the involuntary expense of all
and all other members of society.
We must say that, in light of practical experience,
Schumpeter's scheme is wishful thinking.
Credit expansion financed through printing money
is in practice the very opposite of a way
to combat the economic establishment.
It is the preferred means of survival
for an establishment that cannot or can no longer
sustain the competition of its competitors.
It would not be uncharitable to characterize inflation as a large-scale rip-off in favor of the politically well-connected few
and to the detriment of the politically destitute masses.
It always goes in hand with the concentration of political power in the hands of those who are privileged to own a banking license
7.
Inflation in the form of fractional reserve banking and fiat money is ultimately a self-defeating
Practice, it bears in itself the germs of its own destruction and as we shall see deflation
is the essential vehicle of this destruction.
We can distinguish three scenarios of the halt of inflationary processes.
Fractional reserve banking melts down whenever and for whatever reason a sufficiently big
A significant number of bank customers decide to demand redemptions of their deposits.
Any increase of the quantity of money can engender a sequence of boom and bust.
If A, the new money first reaches the capital markets and if B, the entrepreneurs do not
anticipate that the new money will lead to a rise in prices over the level they would
otherwise have reached.
The erroneous calculations of the entrepreneurs lead them to shift resources from sustainable
investment projects into ones that cannot be completed with the available quantities
of factors of production.
And the erroneous calculations are also reflected in, not caused by, a below equilibrium interest
rate.
When the market participants discover their errors, the more or less large number of unsustainable
firms goes bankrupt, thus upsetting the balance sheets of the banks and entailing a financial
meltdown.
First, there can be a liquidity crisis of the fractional reserve banking system that
ends up in a bank run, that is, in a sharp decline of the demand for money substitutes.
The concomitant drastic reduction of the money supply entails a corresponding decrease of
money prices, which negatively affects all market participants who have financed their
operations through debt.
The lower nominal selling receipts after the run do not suffice to pay back the debts contracted
at the higher nominal price level of the past.
This in turn jeopardizes the positions of many creditors who, when they do not get their
money back, cannot pay back their creditors.
Thus, the liquidity crisis of our fractional reserve banks entails a general financial
meltdown.
Rock bottom is reached in a commodity money system when all money substitutes have vanished
and the market participants have turned to using the money commodity itself or use competing
After the deflation has cleaned up the economic landscape, fractional reserve banking and other forms of financial intermediation will play a less-significant role in the economy. Firms and individuals will, at the margin, turn to financing whatever purchases they make, through personal savings. In short, financial decision-making will be the most important part of the economy.
This first scenario was very common in the 19th century and up to the Great Depression, which, according to Irving Fisher in the early Chicago School, was all about debt deflation entailed by liquidity crisis of fractional reserve banking.
The scenario became less important after the introduction of deposit insurance which for all practical purposes established 100% reserve banking in the U.S.
Notice that in the Great Depression deflation was not allowed to complete its work.
The Fed inflated the economy after deflation had destroyed a great number of banks, reducing their total number to some 15,000.
These select few, protected by Federal deposit insurance, then surfed on the Fed created inflation and expanded their total assets from $51.4 billion in 1933 to $242.6 billion in 1957.
It could have some relevance, however, in explaining the more recent financial crises
in Russia, Brazil, Argentina and certain Asian countries, in particular if the currencies
of these countries at the time of the crisis could be interpreted as money substitutes
for U.S. dollars.
Second, there can be inter-temporal misallocations of resources when fraudulent fractional reserve
Banks increase the money supply and thereby depress market interest rates below their
equilibrium level.
Then entrepreneurs invest too many of the available resources high up in the physical
production chain and not enough resources in the lower stages of the structure of production.
The result becomes visible after some time when a more or less great number of firms
Banks must file bankruptcy. This in turn jeopardizes their creditors, in particular fractional
reserve banks and leads to the chain of events we described above. The difference between
the second and the first scenario is in the causation of the bank run. In the former,
the bank run starts more or less by accident when one major market participant, be it out
A lot of negligence or due to unforeseen contingencies fails and pulls down a house of cards.
By contrast, in the scenario we are now considering, the bank run is the necessary consequence
of a previous misallocation of resources that resulted from a fraudulent increase of the
money supply.
The question whether this scenario applied to any historical crisis is somewhat controversial.
Many Austrian economists believe it fits the Great Depression and several other economic
crises of the past.
At any rate, it is certainly a conceivable scenario, and it also involves a heavy dose
of money-substitute deflation.
Hence, in this scenario, too, inflation ends up in a deflationary meltdown of the old ways
of finance.
The share of banking and financial intermediation in overall economic activity will be reduced,
and financial decision-making will be even more conservative and decentralized than it
is anyway.
The two foregoing scenarios both involve a more or less sudden decline of the demand
for money substitutes, which entail a more or less rapid physical disappearance of these
and substitutes from circulation, as market participants switch to using base money.
By contrast, in the case of paper money, it is very unlikely that there will ever be a
rapid deflation in our definition, a reduction of the money supply.
The reason is that paper money is protected through legal tender laws and other legislation.
Market leaves barter as the only legal alternative to using paper money, and barter is so much
less beneficial than monetary exchange that market participants typically prefer using
even very inflationary monies rather than turning to barter.
In all known cases, it was only under extreme duress when the purchasing power of their
The foregoing three scenarios cover probably most historical cases in which inflation has been brought to an end.
If we tie this up with our comparative analysis of free and compulsory production of money and money substitutes, we come to the conclusion that deflation is not a mere redistribution game that benefits some individuals and groups at the expense of other individuals and groups.
Rather, deflation appears as a great harbinger of liberty. It stops inflation and destroys the institutions that produce inflation. It abolishes the advantage that inflation-based debt finance enjoys at the margin over savings-based equity finance.
and it therefore decentralizes financial decision-making and makes banks, firms and individuals more prudent and self-reliant than they would have been under inflation.
Most importantly, deflation eradicates the re-channeling of incomes that result from the monopoly privileges of central banks.
It thus destroys the economic basis of the false elites and obliges them to become true
elites rather quickly or abdicate and make way for new entrepreneurs and other social
leaders.
It is highly significant that the authors of the 1931 Macmillan Report, which analyzed
the worldwide financial crisis of the time, recognized and emphasized that deflation was
is foremost a political problem. They clearly saw that deflation brings down the politico-economic establishment, which thrives on inflation and debts, and that it therefore brings about some circulation of the elites.
The late Lord Keynes and his co-authors, among them several leaders of the London banking industry and of the British cooperative and labour union movements, were of course convinced that their country could not do without them.
Deflation puts a break, at the very least a temporary break, on the further concentration and consolidation of power in the hands of the federal government and in particular in the executive branch.
It dampens the growth of the welfare state if it does not lead to its outright implosion.
In short, deflation is at least potentially a great liberating force.
It not only brings the inflated monetary system back to rock bottom,
it brings the entire society back in touch with the real world
because it destroys the economic basis of the social engineers, spin doctors and brainwashers.
In light of these considerations, deflation is not merely one fundamental policy option
The case of Japan might serve as a warning counter-example.
The severe Japanese recession of the early 1990s was both an economic and a political
threat to the establishment. In Japan, the process of consolidation and centralization
of power started right after World War II, when the economic experts within the U.S.
occupation forces imposed Keynesian and socialist policies on their former enemy. By the late
1980s, the process had advanced to such an extent that it was politically impossible
to allow deflation to cleanse the economy and politics.
The Japanese governments of the 1990s sought to fix the economic crisis through increasingly
heavy doses of inflation.
But the only result of this policy was to give a zombie life to the hopelessly bureaucratic
and bankrupt conglomerates that control Japanese industry, banking and politics.
After almost 15 years of mindless inflation, Japan's economic crisis has turned into a
fundamental political crisis that sooner or later will bring the country onto the verge
of revolution.
This is also what will happen to the West if the citizens of our countries let their
governments have a free hand in monetary affairs.
8. In conclusion, let us restate the main points. Deflation is far from being inherently bad.
Quite to the contrary, it fulfills the very important social function of cleansing the economy and the body politic
from all sorts of parasites that have thrived on the previous inflation.
In a word, the dangers of deflation are chimerical, but its charms are very real.
There is absolutely no reason to be concerned about the economic effects of deflation,
unless one equates the welfare of the nation with the welfare of its false elites.
There are, by contrast, many reasons to be concerned about both the economic and political consequences
of the only alternative to deflation, namely, reinflation, which is, of course, nothing but inflation, pure and simple.
The purpose of these pages is not to appeal to the reason of our monetary authorities.
There is absolutely no hope that the Federal Reserve or any other fiat money producer of the world
will change their policies anytime soon.
But it is time that the Friends of Liberty change their minds on the crucial issue of deflation.
False thinking on this point has given our governments undue leeway, of which they have made ample and bad use.
Ultimately, we need to take control over the money supply out of the hands of our governments
and make the production of money again, subject to the principle of free association.
The first step to endorsing and promoting this strategy is to realize that governments do not, indeed cannot, fulfill any positive role whatever through the control of our money.