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Deflation Doesn’t Undo The Problems Caused By Past Inflation – Analysis

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By Frank Shostak*

By a popular way of thinking, it is the role of the central bank to make sure that economy follows a path of stable economic growth and prices. The economy is perceived to be like a spaceship that occasionally slips from this trajectory.Following this way of thinking when economic activity slows down and strays from the path of stable economic growth and stable prices, it is the duty of the central bank to give it a push, which will put it back on track. The push is given by means of a loose monetary policy, i.e., lowering interest rates and raising the growth rate of money supply.

Conversely, when economic activity is perceived to be “too strong,” then in order to prevent an “overheating” it is the duty of the central bank to “cool off” the economy by introducing a tighter monetary stance. This amounts to raising interest rates and slowing down on monetary injections. It is believed that a tighter stance is going to place the economy on a trajectory of stable economic growth and stable prices.

Hence, following this way of thinking it makes a lot of sense for the central bank to watch the economy all the time and to make the necessary adjustments in order to keep it on a stable growth path. It also appears as if a tighter monetary stance could offset the effects of the previous loose monetary stance.

Why Tight Monetary Stance Cannot Erase the Effects of an Easy Stance

A tight monetary stance cannot undo the negatives of the previous loose stance. A tighter stance cannot reverse the misallocation of resources that occurs during a loose one.

According to Percy L. Greaves Jr. in The Causes of the Economic Crisis, and Other Essays before the Great Depression,

Mises also refers to the fact that deflation can never repair the damage of a priori inflation. In his seminar, he often likened such a process to an auto driver who had run over a person and then tried to remedy the situation by backing over the victim in reverse. Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

A tighter monetary stance while likely to undermine various bubble activities is also likely to generate various distortions, thereby inflicting damage to wealth generators. A tighter stance is still intervention by the central bank, and in this sense it does not result in the allocation of resources in line with consumers’ top priorities. Hence, it does not follow that a tighter stance can reverse the damage caused by inflationary policy.

Freeing the economy from central bank interference with interest rates and money supply will arrest the process of wealth destruction. This is going to strengthen the process of real wealth generation. With a greater pool of real wealth, it is going to be much easier to absorb various misallocated resources. (Note that some resources, however, due to their nature will be probably much harder to absorb. For instance, a demand for some capital goods and certain human skills could disappear or weaken significantly in the new free market environment.)

Can Central Bank Policies Keep the Economy on Stable Growth Path?

Most experts are of the view that a major obstacle to getting on the path of stable growth and stable prices is the fluctuation of the federal funds rate around the neutral interest rate.

The neutral interest rate, it is held, is one that is consistent with stable prices and a balanced economy. What is required, then, is for Fed policymakers to successfully target the federal funds rate toward the neutral interest rate. According to this view, the main source of economic instability is the variability in the gap between the money market interest rate and the neutral interest rate.

In this framework of thinking the neutral interest rate is established at the intersection of the aggregate supply and aggregate demand curves. If the market interest rate falls below the neutral interest rate, investment will exceed savings, implying that aggregate demand will be greater than the aggregate supply. Assuming that the excess demand is financed by the expansion in bank loans, this leads to the creation of new money, which in turn pushes the general level of prices up.

Conversely, if the market interest rate rises above the neutral interest rate, savings will exceed investment, aggregate supply will exceed aggregate demand, bank loans and the stock of money will contract, and prices will fall. Hence whenever the market interest rate is in line with the neutral interest rate, the economy is in a state of equilibrium and there are neither upward nor downward pressures on the price level.

The main problem here is that the neutral interest rate cannot be observed. How can one tell whether the market interest rate is above or below the neutral interest rate?

Despite the fact that the neutral interest rate cannot be observed, economists are of the view that it could be estimated by various indirect means. In order to extract the unobservable neutral interest rate, economists now employ sophisticated mathematical methods such as the Kalman filter.1 In the process of attempting to ascertain the stable growth path, economists assume the existence of aggregate supply and demand curves. The intersection of these curves generates the so-called equilibrium that supposedly corresponds to the growth path of economic stability.

But the law of supply and demand as presented by popular economics does not originate from the facts of reality but rather from the imaginary construction of economists. None of the figures that underpin the supply and demand curves originate in the real world; they are purely imaginary. According to Mises,

It is important to realize that we do not have any knowledge or experience concerning the shape of such curves. (Human Action, p. 333)

Yet economists heatedly debate the various properties of these unseen curves and their implications regarding government and central bank policies.

Why General Equilibrium Is a Fiction

The existence of a general equilibrium as depicted by the intersection between the overall economy supply curve with the overall economy demand curve is questionable. The economy as such does not exist apart from individuals. Hence, something that does not exist cannot strive to some kind general equilibrium. The concept of equilibrium is only relevant to individuals.

Equilibrium in the context of an individual’s conscious and purposeful behavior has nothing to do with the imaginary equilibrium as depicted by popular economics. Equilibrium is established when individuals’ ends are met. When a supplier is successful in selling his supply at a price that yields profit, he is said to have reached an equilibrium. Similarly, consumers who bought this supply have done so in order to meet their goals. Again, every individual in his own context achieves his equilibrium whenever he reaches his goal.

Observe that in the absence of central bank interference the interest rate that will be established is going to be in line with individuals’ various goals. This interest rate will reflect individuals’ goals and not the wishes of central bank planners. Thus, some individuals might discover that the interest rate that they would have to pay is much lower than what they are ready to pay. For some other individuals the free market interest rate may turn out to be far too high. Consequently, they are going to be out of the market. It is the marginal lender and the marginal borrower that set the market interest rate, not the intersection of the supply and the demand curves.

Now, once policies are implemented to achieve the neutral interest rate, which supposedly reflects the so-called general equilibrium as established by the mathematical models, this is likely to be in contradiction of what the free market would have established. As a result, this is going to generate the misallocation of resources and the weakening of the process of real wealth generation, i.e., economic impoverishment. By setting the federal funds target rate, Federal Reserve policymakers are pretending that they have the numerical information about the interest rate that corresponds to the growth path of stable economic growth and stable prices.

The failure of various centrally planned economies such as the former Soviet Union is testimony that central authorities’ attempt to push the economy toward the growth trajectory as dictated by the government bureaucrats results in an economic disaster.

  • 1.Thomas Laubach and John C Williams, “Measuring the Natural Rate of Interest” (working paper, Board of Governors of the Federal Reserve System, November 2001), https://www.federalreserve.gov/pubs/feds/2001/200156/200156pap.pdf. John C. Williams, “The Natural Rate of Interest,” FRBSF Economic Letter, no. 2003–32, October 31, 2003, https://www.frbsf.org/economic-research/publications/economic-letter/2003/october/the-natural-rate-of-interest/.

*About the author: Frank Shostak‘s consulting firm, Applied Austrian School Economics, provides in-depth assessments of financial markets and global economies. Contact: email.

Source: This article was published by the MISES Institute

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MISES

The Mises Institute, founded in 1982, teaches the scholarship of Austrian economics, freedom, and peace. The liberal intellectual tradition of Ludwig von Mises (1881-1973) and Murray N. Rothbard (1926-1995) guides us. Accordingly, the Mises Institute seeks a profound and radical shift in the intellectual climate: away from statism and toward a private property order. The Mises Institute encourages critical historical research, and stands against political correctness.

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