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US economy, Ben Bernanke and recession
Gerard Jackson
If we are to get any indication which way the US economy will go in the near future it is necessary to see how Ben Bernanke, the new Fed Chairman, defines inflation. He has alluded to the use of open market operations to control the price level. If prices, for example, started to decline he would apparently use the Fed to buy securities and so expand the money supply in order to bid prices back up. This is not a policy we should welcome.
However, there seems to be some confusion regarding Bernanke’s views on inflation. If he interprets any movement in general prices as a purely monetary phenomenon then all of us could end up in a lot of trouble.
Deflation is usually defined as a falling price level. In reality deflation is a contracting money supply. It is true that if the contraction is allowed to go on long enough prices must begin to fall, which means real incomes will rise. If wage rates are not allowed to adjust to the new monetary situation persistent widespread unemployment will emerge as was the case in the 1930s.
However, and it is a vitally important however, not every general fall in prices is caused by a sustained monetary contraction. Once England returned to the gold standard after her victory over Napoleon a secular decline in prices set in until about 1852 when the California and Australian gold discoveries began to have an impact on general prices.
This post-Napoleonic period was marked by a number of boom-bust episodes, that is inflationary bursts followed by severe monetary contractions. But this only happened whenever the banking sector seriously departed from the gold standard by creating excess bank deposits. Without these deviations there would have been a steady decline in prices brought about by increased productivity.
The gold discoveries caused a sudden rise in prices which levelled out in about 1854, after which prices remained comparatively stable until about 1874. This is the kind of situation that would warm the heart of any monetarist. But the classical economist John Elliott Cairnes, considered by some to be “the last of the classical economists”, rightly argued that the situation was deceptive.
He stressed that stable prices had concealed a serious inflation which, when the necessary price adjustments are made, depreciated gold by about 20 per cent to 25 per cent. (I should add that his reasoning regarding the microeconomic effects of the gold discoveries closely corresponded to that of Richard Cantillon). What Elliott had done was to expose the fallacy of the stable price level, which falsely claims that if prices are stable there is no inflation, even if the money supply is quickly growing.
From about 1874 until the gold discoveries of the 1890s prices maintained a steady decline. This period has sometimes been called the “great deflation’ or just one of depression. There was no deflation and there was no prolonged depression. What happened was that output expanded faster than the gold supply, just as it did after the Napoleonic Wars, thereby raising the purchasing power of gold.
Investment embodying new technologies continually increased the productivity of labour and so lowered production costs. Because new investments caused marginal costs to fall the value of the workers’ marginal product rose. The point is that increasing productivity raised the demand for money and so its price in terms of other goods.
If the governments of the day had have bought into the myth of the necessity for a stable price level these periods would have been marked as one of inflation and financial crises. As it was, any financial crises were, as I have already pointed out, caused by the banking system departing from the gold standard. The current situation is the result of a banking system without a gold standard.
This brings us back to Bernanke. It has been suggested that he believes that falling prices do not necessarily indicate deflation. This is the goods news. The bad news is that he seems to believe that such a situation is one of excess supply. But as the classical economists, I really should say pre-Keynesian economists, pointed out there can be no such thing as general over supply. What seems to be over supply is what was called a severe disproportionality or what we today call disequilibrium marked by prices exceeding the costs of production.
In a progressing economy on a gold standard prices will be declining because falling production costs are increasing the supply of goods while simultaneously maintaining profit margins. If Bernanke interprets a situation where improved techniques and capital goods are driving down prices as one of deflation he will expand the money supply and create malinvestments by distorting prices.
Apart from Bernanke’s views, there is also the extraordinary view that inflation generally occurs because of economic weakness. The only weakness that causes inflation is to be found in the economic fallacies that rule the central banks.
In support of this view it is held that previous booms happened in the absence of inflation. Those who cling to this view have been blinded by the fallacy of inflation being defined by a rising price level rather than an expanding money supply. It is this thinking that still has it that the 1920s were inflation-free when in fact M1 grew by about 100 percent.
It was this monetary expansion that triggered the boom and the frenzied speculation to which it gave birth: and it was the Fed’s attempt to curb the speculation by freezing the money supply that brought about the crash. In the absence of genuine inflation there would have been no boom, no crash and certainly no Great Depression.
It is clear that central bankers still have little idea of how changes in the money supply affect the price structure and the pattern of production. What we are left with is a guessing game in which we have to examine hypothetical entrails in an effort to determine how the new Chairman will interpret economic data.
At the end of the day the US will still have another recession followed by another boom followed by another … If the Democrats are in opposition when the next recession strikes they and the leftwing MSMP (MainStream Media Party) will blame the Republicans. If the Democrats are in power when a recession starts they and their media collaborators will blame both the Republicans and capitalism.
In the meantime, the Fed will just chug along making the same old destructive mistakes.
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 14 November 2005