February 4, 2011 – Freeread

This entry is part 29 of 50 in the series 2011A

The Problem of Deflation

There are a number of arguments made for returning to a gold standard. One of them is that the economy will be more stable. Unfortunately, as we have just illustrated, this has not been historically the case.

It is true that one can find other reasons than problems with gold and silver for many of the crises during the metallic years, but one can do the same thing concerning fiat money since 1933 or 1972 when we were taken off the gold standard.

The fact is that we have had monetary problems with or without the gold/silver standard including the Great Depression during the standard and the Great Recession starting 2008 without it. It is a sad fact that there is a factor involved much more dangerous than what is the basis for our money and that is the human frailties of those who control or have access to the nation’s wealth. We not only need a sound money system but something needs put in place that will limit the damage our fearless leaders can do to it.

So, two things need to be in place if we are to have a consistently good economy. First a sound money system and secondly sound management over the money.

That said; let us continue examining the pros and cons of possible foundations of our money supply, the first half of any monetary solution.

Those who support the gold standard make a number of additional arguments in its favor. Right up there with the belief that it makes for a more stable economy is that it puts overspending in check and thus limits inflation.

Now it is true that if we had a pure gold standard (which we have never had) where each dollar spent was backed up 100% with gold and fully redeemable in gold then deficit spending would be very difficult but not impossible. They would most likely create some I.O.U. or promissory note system that would evolve into fiat money like we have today. Then as soon as there was a major crisis what’s left of the gold standard would be thrown out the window as it has been so many times in the past.

Before we had the graduated income tax the gold standard helped to reign in spending but now that it is in place our leaders have the power of unlimited taxation. If a gold standard limited the government’s ability to create inflationary dollars then they would just seek to tax us more and after they drained the last possible dollar from all taxpayers, rich and poor, they would find a way to negate the discipline of the gold standard so they could borrow and spend even more.

All governments are like addicts. They are addicted to spending and will do anything to get their fix. This tells us that a logical money system only supplies us with part of the solution. The other part has to come from the citizens. They must control their employees – our government representatives. This means that any monetary system by itself is not a magic bullet. Even so, the basis of money is the foundation of our economy and all possible solutions must be examined.

We must create the best possible foundation for money and the people must make sure the contractors creating the rest of the building remain honest and do the job we hired them to accomplish.

While it is true that the economies of the nations of the world have had their problems on and off the gold standard it is true that historically a gold or gold-silver standard does hold inflation in check better than pure fiat money. Some gold standard advocates go so far as to insist that and ounce of gold has always been worth the same amount over the centuries – which is an ounce of gold.

This is not logical thinking and is like saying an ounce of silver is worth the same now as it always has been just because it’s an ounce of silver, or a gallon of oil equals a gallon of oil. If gold and silver are always worth the same amount then their ratio of value should be fairly stable. Since there is 17.5 times more silver in the earth’s crust than gold in 1792 the Congress originally set the ratio value at 15:1, very close to the natural ratio. This ratio was problematic so they raised it to 16:1 in 1834. Since going off the artificial bimetallic standard the ratio has fluctuated from about 12:1 to 100:1.

Some of the fluctuations have occurred over a fairly short period of time. For instance, in 1980 the ratio was 17:1 and then in 1991 jut leaped to 100:1. Around the 2008 meltdown it was 80:1 and by 2011 it hovered around 50:1.

So, if a metallic money is always has the same intrinsic value then why the huge fluctuations in ratio? There’s no reason to believe that an ounce of gold always has the same value any more than an ounce of silver.

The fact is that even though gold and silver have held a high basic value over the centuries their value has fluctuated quite a lot. Whereas the fluctuation of fiat money is almost always toward inflation the precious metals go both ways. Sometimes their value is inflated and other times they suffer deflation. This is proclaimed to be a good thing, but is it?

A drastically overlooked fact by gold standard advocates is that, while too much inflation is admittedly a problem, any equal amount of deflation is much worse.

Let us take the deflation and inflation of the housing market before and after 2008. Before the housing meltdown it often took only a year or two for a home to increase in value 20%. Was there a big crises when this happened? No. Were homeowners complaining? Not really. Instead, they were bragging about their increased assets.

Was there a problem for anyone? There was some problem for buyers but because the interest rate was low, and they felt their purchase was a good investment, few were complaining.

Then as we approached the meltdown of 2008 home prices began to fall. Depending on the area of the country it did not take long before a corresponding 20% drop in prices was witnessed.

Was the problem of a 20% deflation equal in severity to a 20% inflation?

Not by a long shot.

Whereas most people saw the last 20% inflation as a minor annoyance the deflation of our real estate has caused untold grief and stimulated an economic collapse that has diminished all areas of our financial lives.

The same goes for inflation and deflation of money in general. A measured inflation decreases the purchasing power of our money, but because wages also go up most people deal with it as a minor inconvenience.

On the other hand, even a small amount of deflation can spell disaster for people in a number of ways not seen with normal inflation. Here are some.

(1) Those with high mortgages will see the amount they owe become more than the value of their house. This gives them incentive to not pay the loan and let the property go to foreclosure.

(2) Overall deflation is particularly hard on those who are in debt of any kind and have to use loans to finance their business. Agriculture always suffers with deflation. The price of commodities sinks whereas debt rises.

(3) In times of deflation money supply is tight, financing is difficult, investment is down, unemployment is high and overall life is miserable for those affected.

The most famous period of extended deflation was The Great Depression. Between 1929-1933 the money supply decreased by about 33% followed by the money income falling by a whopping 53%. In addition the velocity of money fell by about a third – this is the number of times existing money changes hands.

The wholesale price index decreased by 32%, the consumer price index dropped 23% and farmers received 52% less for their products. In addition, the value of global imports and exports decreased by almost 60%.

Then to top it all off unemployment went from 3.2% in 1929 to 25.2% in 1933.

You get the picture. The greatest contraction corresponded to the greatest depression.

Data taken from:
Monetary Central Planning and the State, Part 11: The Great Depression and the Crisis of Government Intervention by Richard M. Ebeling, November 1997. online book at:http://www.fff.org/freedom/1197b.asp

A Monetary History of the United States, 1867-1960; Milton Friedman & Anna Jacobson Schwartz, Pages 301-302

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