When I was an undergraduate majoring in economics in the late '60s and early '70s, several of my professors made much of the distinctions between "trotting," "galloping," and "creeping" inflation. Trotting inflation was usually defined as a 5 to 10 percent annual rate of increase in the general level of prices that, if not controlled, might accelerate into a galloping inflation of 10 to 20 percent a year; galloping inflation ran the risk of becoming a "runaway" inflation; runaway inflation could change into a hyperinflation; and hyperinflation might lead to a monetary collapse if not stopped in time.

But creeping inflation, my fellow students and I were told, need not be a problem. Creeping inflation was a rate of general price increase of 1 to 5 percent a year. A creeping inflation of 3 to 5 percent could still significantly eat away at the purchasing power of money when continued over many years, but it was "manageable." Furthermore, a low creeping inflation could be good for the economy.

After John Maynard Keynes wrote his famous book, The General Theory of Employment, Interest and Money, in 1936, the economists who became known as the Keynesians argued that workers suffer from "money illusion." Or in Keynes's own words, "A movement by employers to revise money-wage bargains downward will be much more strongly

resisted than a gradual and automatic lowering of real wages as a result of rising prices."

Suppose that a general economic depression develops in an economy and prices, in general, fall by, say, 20 percent. If workers were to accept an equivalent cut in the general level of wages, employers' labor costs would have declined in line with the prices they now receive for the products they sell. Employers could afford to maintain production and employ the same number of workers as they had before the depression began. Furthermore, workers would be no worse off in terms of their real incomes. It is true that their money wages would now be 20 percent lower, but so, too, would be the prices of the goods they bought with their smaller money incomes. At the lower level of money prices, their lower money incomes would still be able to buy the same quantities of goods and services as before the start of the depression.

Keynes, however, argued that workers suffer from "money illusion." They think only in terms of the nominal dollars in their paychecks, not in terms of their "real wages," i.e., in terms of the real purchasing power of what their money wages can buy. As a consequence, workers would strongly resist any significant cut in their money wages, even if the result were to be high and prolonged unemployment.

The answer, Keynes proposed, was to decrease real wages, and, therefore, the cost of hiring labor, through price inflation. Precisely because workers suffer from money illusion, they would not ask for higher money wages to compensate for the loss in their consumer buying power due to the rise in prices. Higher prices for products with relatively unchanged money wages would improve or create the profit margins out of which would come the incentives for employers to expand production and hire back the unemployed.

In the Keynesian view, government budget deficits are the mechanism for bringing this about. Government would take in less tax revenue than it spent on goods and services. The net addition of government spending in the economy through money creation (or borrowing of "idle" savings accumulating in banks) to finance the budget deficit would be the device through which "aggregate demand" could be stimulated and prices "creepingly" pushed up.

Keynes's argument for a little bit of managed inflation as a healthy stimulus to production and employment had, in fact, been made many

times before him and had been criticized, as well, as a merely temporary panacea. For example, Francis A. Walker, one of the most prominent American economists of the late 19th century, argued in his book Money, Trade, and Industry (1889) that a "gradual . . . inflation upon profits is very direct and simple. . . . It gives a fillip to the zeal of the employing classes, and in the immediate present promotes production without necessarily inducing any [negative] reaction whatsoever. . . . It will have the maximum of good and the minimum of evil effects" as long as it is "a slowly progressive depreciation of money."

But the belief that a permanent stimulus for greater production and employment can be secured by a steady and low rate of price inflation was criticized by the Swedish economist Knut Wicksell in his book Interest and Prices (1898):

"If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts; with the result that its supposed beneficial influence would necessarily be reduced to a minimum. Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little fast so as to be certain of catching their trains. But to achieve their purpose they must not be conscious of the fact that their watches are fast; otherwise they become accustomed to take the extra few minutes into account and after all, in spite of their artfulness, arrive too late."

In this century, first Irving Fisher and then Milton Friedman argued the same point as Wicksell. They pointed out that prices for finished consumer goods tend to be relatively flexible and responsive to changes in market demand. The prices of factors of production, such as labor, on the other hand, tend to be contractually fixed for longer periods of time. As a result, if there is an unexpected increase in general market demand due to inflation, prices of finished goods will begin to rise sooner and before the prices of the factors of production. Profit margins will be temporarily widened by the price inflation. But as contracts come up for renewal and general information about the rate of price inflation comes to be known, workers and other resource owners will bargain for higher wages and prices. Why? For two reasons. First, the attempt to expand production simultaneously in many sectors of the economy because of widened profit margins will strain the market for scarce factors of production, naturally resulting in a bidding up of their prices, including the wages of labor.

Second, as workers and resource owners buy goods and services in the market, they soon learn that their money incomes no longer go as far as they used to in the face of rising prices. In their bargaining over wages and resource prices with employers, they naturally will demand money wages and money prices for resources that at least reestablish their previous real income. Both Fisher and Friedman argued that workers over time do not suffer from money illusion. Money, as a medium of exchange, is an abode of purchasing power, and those who use money are concerned with what it will buy in the marketplace. In other words, what matters for income earners are their real wages , not merely their money wages .

Only if the rate of increase in the general level of prices were unanticipated-or not anticipated to the full extent-would the Keynesian gimmickry work. If the rate of general price inflation is correctly anticipated, then all contracts for wages and other resource prices will incorporate that information; resource prices, including wages, will tend to rise at the same average rate as the general price level. Profit margins will not be artificially widened, and there will be no permanent stimulus to greater production and employment. The amount of production and employment will reflect the actual, underlying market conditions of supply and demand existing in the economy.

Only if the actual rate of price inflation is accelerated ahead of what people expect the inflation rate to be will prices once again rise fast enough relative to the costs of production to make the Keynesian illusion temporarily reappear. But this means that if inflation is to have its stimulative impact, it must be accelerated from a "creep" to a "trot." When "trotting" inflation no longer does the trick, it must be speeded up to a "gallop." And when a galloping inflation no longer suffices, it must be allowed to "run away." When runaway inflation fails to deliver the desired level of employment. . . .

The idea of a steady and successfully government-managed "creeping inflation" to ensure some desired rate of economic growth and increase in employment fell by the wayside in policy circles in the 1970s and 1980s under the attacks of monetarists such as Milton Friedman and another group of economists known as the rational-expectations theorists.

But it seems that fallacious ideas never die-especially in economics; they just retreat into hiding to reappear some other day. As an example of this, the case for creeping inflation is back.

In August 1996, the Washington-based Brookings Institution released a Policy Brief by George Akerlof, William Dickens, and George Perry, entitled "Low Inflation or No Inflation: Should the Federal Reserve Pursue Complete Price Stability?" They argue that if the board of governors of the Federal Reserve System follows a strategy of zero inflation, they will bring about unnecessary unemployment and less growth than would be possible otherwise.

Constant changes in market conditions, the authors correctly point out, require appropriate adjustments in the distribution of labor among the various sectors of the economy as well as adjustments in the structure of relative wages, reflecting the changing patterns of employers' demands for different types of labor. If price inflation is zero, they again correctly reason, some money wages will have to rise where the demand for labor is increasing and some money wages will have to decline where the demand for labor is decreasing.

But the authors say,

"Employers almost never cut their employees' wages because they fear that doing so would cause serious morale and staff retention problems. . . . Most people consider it unfair for a firm to cut wages, except in extreme circumstances. . . . Downward wage rigidity is indeed an important feature of the economy."

As a result, in those sectors of the economy where money wages may have to fall but do not, employers "keep relative wages too high and employment too low." On the other hand, most workers "do not consider it unfair if a firm fails to raise [money] wages in the face of high inflation."

On the basis of this reasoning, they propose a monetary policy of "moderate inflation." If market conditions change, the necessary adjustments in the structure of relative wages to attract workers into some sectors of the economy and away from others can occur without having to cut anyone's money wage. Money wages can be kept the same in those parts of the economy where labor demand has gone down, while the increases in the money supply to generate the moderate price inflation can be used to cover a necessary rise in money wages in those sectors where workers need to be attracted.

To avoid "serious morale" problems-the new explanation for the old Keynesian presumption of "money illusion" among workers-the Federal Reserve, therefore, should make a new version of "creeping inflation" the goal of monetary policy.

In a September 30, 1996, commentary in the (London) Financial Times , entitled "Inflation Apologists," columnist Michael Prowse scathingly took these authors to task for resurrecting this fallacious building block of old-fashioned Keynesian economics. He pointed out:

"In a zero inflation world, people could learn to accept the need for occasional cuts in money wages, just as they now accept cuts in inflation-adjusted wages. To assume this is impossible is to assume that people are permanently irrational-a poor, if not insulting, assumption on which to base any economic theory. . . . With zero inflation, relative price signals would be clearer than they are today. . . . Capitalism would function even more efficiently. And the jobless rate would tend to be lower, not higher. The pessimism of the new inflation apologists is quite unwarranted."

Is zero-price inflation, therefore, the desirable target for a market economy and the free society? If it is, then this must imply that there remains, even in the free society, a monetary central-planning agency that has the power to implement the necessary monetary policy to bring it about. But if government central planning can be demonstrated to be economically irrational in all other aspects of economic life, on what basis can it be presumed to be able to work-and work correctly-in monetary matters? And if monetary central planning can be shown to be no less irrational than all other forms of central planning, then what should be the monetary system of a free society?

by Richard M. Ebeling, February 1997

One of the most influential economists during the first 30 years of the 20th century was Yale University professor Irving Fisher. In 1896, he published a book entitled Appreciation and Interest . He argued that price inflations and price deflations can have a disturbing effect on the relationship between debtors and creditors if the inflations and deflations are not correctly anticipated by borrowers and lenders.

The rate of interest, he explained, is the price for borrowing money and having use of the resources and commodities that a sum of money can purchase over a period of time. Lenders are willing to part with their money for the period of the loan because they receive a premium - interest - along with return of their principal. The interest represents an additional amount of purchasing power for goods and services. It is the reward for the lender's forgoing the use of his money during the loan period.

Suppose that creditor and debtor have agreed on a rate of interest of, say, 5% for a loan covering a one-year period. Now suppose that during this one-year period, prices in general rise unexpectedly by 3%. When the loan is paid back with its 5% interest, the lender will discover that to buy the same quantity of goods that the principal of the loan had been able to purchase in the market a year earlier, he will now have to spend the principal plus 3% of his interest income. The real gain in buying power from having lent this sum of money, therefore, will not be 5%, but in fact only 2%. The unanticipated price inflation will have eroded three-fifths of the real value of his interest income.

On the other hand, imagine that a similar type of agreement is made between creditor and debtor for a 5% rate of interest on a one-year loan, but prices in general unexpectedly decline by 3% during that year. When the loan is paid off at the end of the year, the lender will discover that because of the unanticipated price deflation, the principal he lent has 3% greater purchasing power than at the beginning of the year. The real gain in buying power from the lender's point of view, therefore, is 8%, not merely the 5% interest contracted for in the loan agreement.

In the first case - that of unexpected price inflation - the borrower will pay back his loan in depreciated dollars. The burden of his debt will be diluted because of the decline in the value of money during the period of the loan.

In the second case - unexpected price deflation - he will pay back his loan in appreciated dollars, and the burden of his debt will have been increased because of the increase in the value of money during the period of the loan.

Irving Fisher argued that if the rate of price inflation or price deflation could be correctly anticipated by the transactors to the loan agreement, then neither creditor nor debtor would gain or lose during the period of the loan. Why? Because knowing that money would either lose or gain some given percentage in purchasing power over this period of time, borrowers and lenders would adjust the terms of the loan to reflect the expected change in the general level of prices.

In the case of the 3% price inflation, the nominal rate of interest would be set at 8%, so that when the loan is paid off, the lender still receives his gain of 5% in real purchasing power. And in the case of 3% price deflation, the nominal rate of interest would be set at 2%, so that when the loan is paid off, the lender receives his real gain of 5% in real purchasing power.

In the real world, however, Fisher said, changes in the general level of prices are unlikely to be perfectly and correctly anticipated by lenders and borrowers. As a consequence, there is always the possibility of unforeseen and unagreed-to gains and losses by creditors and debtors.

Furthermore, Fisher argued, unexpected changes in the general level of prices can have disruptive effects on production and employment in the economy as a whole. This was a theme that he developed in his 1911 work, The Purchasing Power of Money, and that he popularized in a series of books, such as his Elementary Principles of Economics (1912), Stabilizing the Dollar (1920), and The Money Illusion (1928), and in dozens of articles he published throughout the 1920s.

He said that during a period of unexpected price inflation or price deflation, prices for finished goods and services and the prices for resources and labor change at different times and to different degrees. As a result, profit margins between the prices for finished goods and the means of production can be artificially and temporarily increased or decreased, resulting in fluctuations in production and employment in the economy.

Prices for finished consumer goods, Fisher explained, tend to be fairly flexible and responsive to changes in the level of market demand. On the other hand, resource prices, including the wages for labor, tend to be fixed for periods of time by contract. (See "Monetary Central Planning and the State, Part I," in Freedom Daily , January 1997.)

During periods of unexpected price inflation, the profit margins between consumer-goods prices and resource prices are artificially widened, creating an incentive for employers to try to expand output to take advantage of the increased return from sales. This, he argued, is the cause of the "boom," or expansionist, phase of the business cycle.

But the boom inevitably comes to an end when resource prices, including wages, come up for contractual renegotiation. Resource owners and laborers, in a market environment of heated demand for their services, bargain for higher prices and money wages to compensate for the lost purchasing power they have suffered while their money incomes have been contractually fixed in the face of rising prices.

The "bust" or contractionist phase of the business cycle then sets in, as profit margins narrow in the face of the new higher costs of production and as employers discover that they have overexpanded and overextended themselves in the earlier boom period.

During periods of unexpected price deflation, profit margins between consumer-goods prices and resource prices are artificially narrowed or wiped out, as consumer-goods prices are declining while resource prices and wages temporarily remain fixed at their contractual levels. Employers have an incentive to reduce output to economize on costs and reduce loses, generating a general economic downturn. The diminished profits or losses are eliminated when resource prices (including wages) come up for contractual renegotiation. Rather than risk losing their businesses and jobs, resource owners and workers moderate their price and wage demands to reflect the lower prices in the marketplace for their products.

Furthermore, since consumer-goods prices, in general, are declining, resource owners and workers can accept lower resource prices and money wages. In real buying terms, they will be no worse off than before the price deflation began.

If price inflations and price deflations could be perfectly anticipated, the changes in the purchasing power of money could be incorporated into resource and labor contracts, with profit margins being neither artificially widened nor narrowed by the movements in the general level of prices. The business cycle of booms and busts would be mitigated or even eliminated.

Unfortunately, Fisher again argued, such perfect foresight is highly unlikely. And unless some external force is introduced to keep the price level stable - to eliminate both price inflations and price deflations - Fisher concluded that, given the monetary institutions prevailing in most modern societies during the time he was writing, the business cycle would remain an inherent part of a market economy.

Irving Fisher's solution was to advocate a stabilization of the price level . What was needed, he insisted, was a monetary policy that would ensure neither price inflation nor price deflation. In Stabilizing the Dollar (1920), Fisher stated:

"What is needed is to stabilize, or standardize, the dollar just as we have already standardized the yardstick, the pound weight, the bushel basket, the pint cup, the horsepower, the volt, and indeed all the units of commerce except the dollar. . . . Am I proposing that some Government official should be authorized to mark the dollar up or down according to his own caprice? Most certainly not. A definite and simple criterion for the required adjustments is at hand - the familiar "index number" of prices. . . . For every one per cent of deviation of the index number above or below par at any adjustment date, we would increase or decrease the dollar's weight (in terms of purchasing power) by one per cent."

How would the government do this? By changing the quantity of money and bank credit available in the economy for the purchase of goods and services. In his 1928 volume, The Money Illusion , Fisher praised the Federal Reserve Board - the American central bank's monetary managers - for following a policy since 1922 close to the one he was advocating. Though only a "crude" beginning, "stabilization ushers in a new era for our economic life . . . adding much to the income of the nation," he claimed.

"The dollar . . . has been partially safeguarded against wide fluctuations ever since the Federal Reserve System finally set up the Open Market Committee in 1922 to buy and sell securities, especially Government bonds, for the purpose of influencing the credit situation. . . . When they buy securities they thereby put money into circulation. . . . When they sell, they thereby withdraw money from circulation. [Along with the Federal Reserve's control over bank reserves and the discount rate at which it directly lends to banks, through Open Market Operations] the Federal Reserve does and should safeguard the country . . . against serious inflation and deflation. . . . This power, rightly used, makes the Federal Reserve System the greatest public service institution in the world."

Through the power of the Federal Reserve System, Fisher happily pointed out, America had established a "managed currency," guided by the policy goal of a stable price level.

Even on the eve of the great stock market crash that occurred during the last two weeks of October 1929, Irving Fisher declared on September 5, 1929, "There may be a recession in stock prices, but not anything in the nature of a crash." And on October 16, 1929, Fisher insisted:

"Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels. . . . I expect to see the stock market a good deal higher than it is today within a few months."

The great American experiment in monetary central planning for price level stabilization during the 1920s ended in disaster. Along with the government's interventionist responses to the economic crisis, first by the Hoover administration and then with even greater force during the Roosevelt administration's New Deal, America's monetary central planners created the decade-long Great Depression.

What exactly had the Federal Reserve System done in the 1920s, in terms of monetary policy? Why, in fact, did this policy end up being a recipe for disaster? And why did the responses by the Hoover and Roosevelt administrations exacerbate the crisis, turning it into America's Great Depression?

by Richard M. Ebeling, March 1997

The Great Depression was not the result of "reckless capitalism" combined with "passive, indifferent government." The Great Depression was caused by monetary mismanagement by America's central bank, the Federal Reserve System. And the Depression's intensity and duration were the result of government interventionist and collectivist policies that prevented the required readjustments in the economy that would have enabled a normal recovery in a much shorter period of time.

The roots of the Great Depression were laid with the establishment of the Federal Reserve System in 1913. While the American monetary system had many serious flaws before 1913 - practically all of them connected with federal and state regulations and controls over the banking industry - the Federal Reserve System became the mechanism for centralization of control over the monetary and banking structures in the United States. And those controls became the mechanism for monetary central planning that generated a large inflation during the period of the First World War, the illusion of "stabilization" in the 1920s, and the reality of the Great Depression in the early 1930s.

In the first seven years after the Federal Reserve came into full operation in 1914, wholesale prices in the United States rose more than 240%. How had this come about? Between 1914 and 1920, currency in circulation had increased 242.7%. Demand (or checking) deposits had gone up by 196.4%, and time deposits had increased by 240%. With the establishment of the Fed, gold certificates began to be replaced with the new Federal Reserve Notes. Unlike the older gold certificates that had 100% gold backing, Federal Reserve Notes had only a 40% gold reserve behind them, enabling a dramatic expansion of currency. Member banks in the new system were required to transfer a portion of their gold reserves to the Fed to "economize" on gold in the

system. At the same time, reserve requirements on deposit liabilities were lowered by 50% from the pre-1914 average level of 21% to 11.60%; and they were lowered even further in June 1917 to 9.67%. Reserve requirements on time deposits were set at only 5% and diminished still more to 3% in June 1917.

The decreased reserve requirements on outstanding bank liabilities created a tidal wave of available funds for lending purposes in the banking industry. And, indeed, between 1914 and 1920, bank loans increased by 200%. Much of the additional lending ended up being in U.S. government securities, especially after American entry in the First World War in April 1917. Between March 1917 and June 1919, bank loans to the private sector increased by 70%, while investments in government securities went up by 450%.

C.A. Philips, T.F. McManus, and R.W. Nelson explained in their important work, Banking and the Business Cycle: A Study of the Great Depression in the United States (1937):

"Had it not been for the creation of the Federal Reserve System, there would have been a [lower] limit to the expansion of bank credit during the War. . . . The establishment of the Federal Reserve System, with its pooling and economizing of reserves, thus permitt[ed] a greater credit expansion on a given reserve base. . . . It is in the operations of the Federal Reserve System, then, that the major explanation of the War-time rise in prices lies."

The years 1920-1921 saw the postwar slump. Prices fell by about 40% during these two years, and unemployment rose to a height of over 10%. But the depression, though steep, was short-lived. Why? Because the American economy still had a great degree of wage and price flexibility. The imbalances in the market created by the preceding inflation were soon corrected with appropriate adjustments in the structure of wages and prices to more fully reflect the new postwar supply-and-demand conditions in the market. But this postwar adjustment did not return prices to anything near the prewar levels. Prices in the United States were still almost 40% higher in 1922 than they had been in 1913. This was not surprising, since the money supply contracted by only about 9% to 13% during this period (according to Monetary Statistics of the United States by Milton Friedman and Anna Schwartz).

Following 1921, the Federal Reserve System began its great experiment with price level stabilization, which Irving Fisher praised so heartily in 1928. (See "Monetary Central Planning and the State: Part II," Freedom Daily , February 1997). That this was the Fed's goal was confirmed by Benjamin Strong, chairman of the New York Federal Reserve Bank through most of the decade and the most influential member of the Federal Reserve Board of Governors during this period. In 1925, Strong said, "It was my belief . . . that our whole policy in the future, as in the past, would be directed toward the stability of prices so far as it was possible for us to influence prices." And in 1927, he once again emphasized, "I personally think that the administration of the Federal Reserve System since the [depression] of 1921 has been just as nearly directed as reasonable human wisdom could direct it toward that very policy [of price level stabilization]."

Did the Federal Reserve succeed in its policy of price level stabilization? An index of wholesale prices, with 1913 as the base year of 100, shows that the average level of prices remained within a fairly narrow band: 1922 - 138.5; 1923 - 144.1; 1924 - 140.5; 1925 - 148.2; 1926 - 143.2; 1927 - 136.6; 1928 - 138.5; 1929 - 136.5. During the entire decade, wholesale prices on average were never more than about 7% higher than in 1922. And at the end of the decade, before the Great Depression set in (1929), wholesale prices, as measured by this index, were in fact about 1.5% lower than in 1922.

Like Irving Fisher in his praise of Federal Reserve policy in 1928, John Maynard Keynes, in his two-volume Treatise on Money (1930), pointed to the Fed's record during the decade, and said, "The successful management of the dollar by the Federal Reserve Board from 1923 to 1928 was a triumph . . . for the view that currency management is feasible."

By how much had the Federal Reserve changed the supply of money and credit during the decade to bring about price level stabilization? The answer to this depends on how one defines the "money supply." Milton Friedman and Anna Schwartz, in their famous Monetary History of the United States, 1867-1960 (1963), estimate that between 1921 and 1929, the money supply increased about 45% or approximately 4.6% a year. They used a definition of money that included currency in circulation and demand and time deposits (a definition known as "M-2").Murray Rothbard, in America's Great Depression (1963), used a broader measurement of the money supply that included currency, demand and time deposits, savings-and-loan shares, and the cash value of life-insurance policies. Using these figures, Rothbard estimated that the money supply had increased by 61.8% between 1921 and 1929, with an average annual increase of 7.7%.

While shares owned in savings-and-loan banks increased by the largest percent of any component of the money supply 318% between 1921 and 1929 it represented only between 4% and 8% of the total money supply during the period, as measured by Rothbard. The cash value of life insurance policies increased by 213% during the period; and it represented between 12.5% and 16.5% of the money supply, as measured by Rothbard.

If the cash value of life insurance policies is subtracted from Rothbard's measure of the money supply, and if deposits at mutual-savings banks, the postal-savings system, and the shares at savings-and-loans are added to Friedman and Schwartz's definition (which, in fact, they do to calculate a broader money definition called "M-4"), the results practically coincide. The money supply, by both measurements, increased by about 54% for the period, with an average annual increase of approximately 5.5%.

During the decade, this monetary increase did not, however, occur at an even annualized rate. Rather, it occurred in spurts, especially in 1922, 1924-1925, and 1927, with monetary slowdowns in 1923, 1926, and late 1928 and early 1929. These were not accidents, but rather represented the "fine-tuning" methods of the Federal Reserve Board of Governors in their attempt to counteract tendencies toward either price inflation or economic recession, with price level stabilization as a crucial signpost of success.

The two main Federal Reserve policy tools for influencing the amount of money in the economy were open-market operations and the discount rate. When the Fed purchases government securities, it pays for them by creating new reserves on the basis of which banks can expand their lending. The sale of government securities by the Fed drains reserves from the banking system, reducing the ability of banks to extend loans.

The discount rate is the rate at which the Fed will directly lend reserves to member banks of the Federal Reserve System. Throughout most of the 1920s, the Fed kept the discount rate below the market rates of interest, creating a positive incentive for member banks to borrow from the Fed and lend the borrowed funds to the market at higher rates of interest, earning the banks a profit. Even when the Fed sold government securities at certain times during the 1920s, member banks were often able to reverse the resulting drains of reserves out of the banking system by borrowing them back from the Fed at the below-market discount rate.

Increases in currency in circulation were a negligible fraction of the monetary expansion, representing less than 1% of the increase. Demand deposits increased by 44.6% and time deposits expanded by 76.8%. This fostered a major economic boom. As Philips, McManus, and Nelson explained in Banking and the Business Cycle :

"As a result of the plethora of bank credit funds and the utilization by banks of their excess reserve to swell their investment accounts, the long-term interest rate declined and it became increasingly profitable and popular to float new stock and bond issues. This favorable situation in the capital funds market was translated into a construction boom of previously unheard-of dimensions; a real estate boom developed, first in Florida, but soon was transferred to the urban real estate market on a nation-wide scale; and finally, the stock market became the recipient of the excessive credit expansion."

Trying to rein in the stock market boom, the Fed all but froze the money supply in late 1928 and the first half of 1929. The monetary restraint finally caught up with the stock market in October 1929.

But why did the stock market downturn develop into the Great Depression? Other than the boom in the stock market, there were few outward signs of an unstable inflationary expansion that would have suggested a need for a recessionary adjustment period to reestablish certain fundamental balances in the economy. The wholesale price index, as we saw, had remained practically unchanged between 1927 and 1929.

Clearly, however, there were forces at work beneath the surface of a stable price level that were generating the conditions for a needed correction in the economy. But depressions had occurred before and recoveries had followed, usually not too long afterwards. Why, then, did this downturn become the Great Depression?

by Richard M. Ebeling, April 1997

Hardly any economists in America anticipated that price-level stabilization during the 1920s would lead to the economic depression that began in October 1929. One of the few who saw a danger in this policy of the Federal Reserve System was Benjamin M. Anderson. As the senior economist for the Chase National Bank of New York City throughout this period, Dr. Anderson authored The Chase Economic Bulletin, which was usually published four to five times every year. He offered detailed analyses of the economic currents in the United States, with special attention to monetary and banking policy and its likely effects on general market conditions. He also often critically evaluated the theories underlying Federal Reserve policy, most particularly the notion of stabilizing the price level as a guide for economic stability.

The most insightful bulletins on this theme were "The Fallacy of 'The Stabilized Dollar'" (August 1920); "The Gold Standard vs. 'A Managed Currency'" (March 1925); "Bank Money and the Capital Supply" (November 1926); "Bank Expansion and Savings" (June 1928); "Two 'New Eras' Compared: 1896-1903 and 1921-1928" (February 1929); "Commodity Price Stabilization as a False Goal of Central Bank Policy" (May 1929); and "The Financial Situation" (November 1929).

He argued that the Federal Reserve had used its powers to reduce the reserve requirements of member banks, had set the discount rate at which member banks could directly borrow from the Fed below the market rates of interest, and had used "open-market operations" to inject new reserves into the banking system. The increase in bank reserves available for lending purposes as a result of these Fed policies had generated a huge increase in demand deposits and especially in time deposits. As a result, a large monetary inflation had been created by the Federal Reserve during the 1920s.

But the price level had remained stable, producing, Benjamin Anderson said, a false sense of economic stability. In 1926 and 1928, he argued that the amount of bank credit created by Fed policy enabled the financing of new investments in excess of actual savings in the economy. Influenced by Joseph Schumpeter's The Theory of Economic Development (1911), Anderson argued that monetary expansion in the form of bank credit lowered interest rates, which attracted additional borrowing for long-term investment projects. These additional bank loans with newly created money enabled investment borrowers to bid resources and labor away from consumption and other uses in the economy and redirect their use towards various types of capital formation. The monetary expansion, in other words, induced the undertaking of investment activities in excess of the actual voluntary savings upon which a stable pattern of investment is ultimately dependent. Thus, Federal Reserve policy was creating a serious imbalance in the savings-investment relationship of the American economy.

Anderson estimated that between 1921 and 1928, demand deposits at Federal Reserve member banks had increased 33.8%, while time deposits (whose minimum reserve requirements had been set by the Fed significantly lower than those required for demand deposits) had increased by 135.1%. The resulting increase in lendable funds, he said, fed real-estate and construction booms and produced a dramatic rise in stock-market speculation.

In February 1929, Anderson pointed out that "excessive bank reserves generate bank expansion, that bank expansion running in excess of commercial needs will overflow into capital uses and speculative employments, and that low interest rates and abundant credit will ordinarily reflect themselves in rapidly rising capital values." In Anderson's view, these all pointed to the inevitability of a corrective downturn.

In May 1929, Anderson again explained that Federal Reserve policy had created a large bank-credit expansion during the decade through its discount-rate policy and its open-market operations. He admitted that the monetary expansion had not produced an absolute rise in the price level, "but I would maintain that our commodity price level would be lower today if this great expansion of bank credit had not taken place. The expansion has had its influence, not in raising commodity prices, but in maintaining them."

During the decade of the 1920s, Anderson said, there had been a great increase in production, and many technological innovations and new cost-cutting efficiencies had been introduced into business. An index of the physical volume of production showed a 34.6% increase between 1921 and 1928. This would have tended to slowly lower prices in the American economy, as the increased supplies of goods and services were offered to the consuming public. But the increase in the money supply had counteracted this natural tendency for prices to have decreased. Argued Anderson:

"Such price changes are wholly beneficial, and should not be interfered with, and such price changes often involve not merely changes in particular prices, but also changes in the general price level of a country, if large groups of producers are involved. . . . 'Right prices' are prices which will move goods and clear the markets, but nobody knows in advance what prices will do this. Experimentation in the markets, with free prices and two-sided competition, is the only way to find out quickly and surely what prices are 'right'. . . . To resist such price changes is to invite trade stagnation."

And in Anderson's view, the Fed's policy of price-level stabilization and various other interventionist policies undertaken by the United States and other countries had prevented prices from telling the truth about actual supply-and-demand conditions. Instead, price-level stabilization had created imbalances that were inevitably going to require a correction.

Right after the stock-market crash, in November 1929, Anderson wrote:

"Basically, our present troubles grow out of the excessively cheap money and unlimited bank credit available for capital uses and speculation from early 1922, with an interruption in 1923, until early 1928. During this period we expanded the deposits of our commercial banks by thirteen and a half billion dollars, and their loans and investments by fourteen and a half billion. There is no intoxicant more dangerous than cheap money and excessive credit. . . . [But] when old-fashioned voices raised in protest, calling attention to old landmarks and old standards, raising prosaic questions regarding earnings and dividends and book value, they were drowned out by an indignant chorus, which chanted that we were in a "New Era," in which book values no longer meant anything, and dividends little, and in which we might capitalize earnings in any ratio that the imagination saw fit to set. . . . To the student of economic history, it is all painfully familiar. He has seen it many times, and in many markets. . . . There is no point in assigning any particular cause for the [stock market] break's coming at the particular time it did. It was overdue, and long overdue. A great collapse was certain the moment that doubt and reflection broke the spell of mob contagion, while the fantastic structure of prices was doomed the moment any considerable number of people began to use pencil and paper."

The goal of price-level stabilization had all been a great illusion, Anderson argued. Furthermore, he pointed out in "Commodity Price Stabilization a False Goal of Central Bank Policy" in May 1929:

"The general price level is, after all, merely a statistician's tool of thought. Businessmen and bankers often look at index numbers as indicating price trends, but no businessman makes use of index numbers in his bookkeeping. His bookkeeping runs in terms of the particular prices and costs that his business is concerned with. . . . Satisfactory business conditions are dependent upon proper relations among groups of prices, not upon any average of prices."

What is important in the market, Anderson was arguing, are the relative price relationships, i.e., the prices for consumer goods relative to the prices of factors of production; the rate of interest as a cost of capital relative to the expected future rate of return from an investment; and the prices of consumer goods relative to the prices for capital goods. It is the pattern of relative demands for goods in comparison to the pattern of relative supplies of those goods that generates the structure of relative prices in the market. And it is this structure of relative prices that creates the margins of profitability that guide entrepreneurial decision-making in the use and allocation of resources and labor for the production of various types of consumer goods and capital goods.

The general price level of commodities in the market is a statistical averaging of a selected group of the individual prices of these goods. And as a statistical average, the general price level submerges beneath its surface all of the individual price relationships that actually influence the use of resources and the production of goods. Beneath the "stability" of the general price level of the 1920s, Federal Reserve policy had manipulated interest rates through monetary expansion and had distorted the profit margins between different types of investments and between the relative profitability of manufacturing consumer goods in comparison to capital goods.

These artificial relative price relationships created by Fed monetary policy had generated imbalances in the economy that were going to require readjustment and correction. As Benjamin Anderson explained in a later bulletin, issued in June 1931, entitled "Equilibrium Creates Purchasing Power: Economic Equilibrium vs. Artificial Purchasing Power," production and prices were out of balance; costs, including wages, were out of balance with the selling prices of goods on the market; and asset and capital values were out of balance with actual market conditions. The imbalances in these price, cost, and production relationships were revealed by the Depression.

But Anderson insisted:

"The restoration of equilibrium cannot be accomplished by government planning. The power does not exist, and the wisdom does not exist, to regulate economic life by governmental edicts. The adjustments must be accomplished piecemeal by individual enterprises seeking to make profits and avert losses, guided by market prices. . . . But this mechanism works well only when prices are free to move, and tell the truth. Artificial valorization of commodities, whether accomplished by a government or by a private combination of producers, perverts the machinery and prevents the necessary adjustments."

For Anderson, it was price and wage rigidities supported or enforced by the government that caused the severity of the Great Depression. By preventing or delaying the necessary adjustments in prices, wages, and production - and the relationships between them - the government hindered the normal working of competitive market forces from bringing the economy back towards a path of balance and growth.

While Benjamin Anderson was one of the few economists in America who questioned the idea that general economic stability would result from a policy of price-level stabilization, in Europe there was a larger number of economists who challenged the arguments of people such as Irving Fisher. The most important among them were the Austrian economists, the leading figures among whom were Ludwig von Mises and Friedrich A. Hayek. They undermined all the theoretical assumptions supporting the price-level stabilization idea and showed why the policies introduced by governments in the 1930s prolonged and intensified what became the Great Depression.

by Richard M. Ebeling, May 1997

Even before the First World War, a number of prominent American economists had criticized Irving Fisher's proposal for stabilization of the price level through monetary manipulation by the government. Frank Taussig of Harvard University, J. Laurence Laughlin of the University of Chicago, and David Kinley of the University of Illinois had forcefully argued that implementing Fisher's scheme would generate more, not less, economic instability.

But it was the Austrian economists who reasoned most persuasively against a price-level stabilization policy in the 1920s. To understand their criticisms of price-level stabilization, it is necessary to begin with Carl Menger, the founder of the Austrian school.

In his Principles of Economics (1871) and in a monograph entitled "Money" (1892), Menger explained the origin of a medium of exchange. Often there are insurmountable difficulties preventing people from trading one good for another. One of the potential trading partners may not want the good the other possesses. Perhaps one of the goods offered in exchange cannot readily be divided into portions reflecting possible terms of trade. Therefore, the transaction cannot be consummated.

As a result, individuals try to find ways to achieve their desired goals through indirect methods. An individual may first trade away the good in his possession for some other commodity for which he has no particular use. But he may believe that it would be more readily accepted by a person who has a good he actually wants to acquire. He uses the

commodity for which he has no direct use as a medium of exchange. He trades commodity A for commodity B and then turns around and exchanges commodity B for commodity C. In this sequence of transactions, commodity B has served as a medium of exchange for him.

Menger went on to explain that, over time, transactors discover that certain commodities have qualities or marketable attributes that make them especially serviceable as media of exchange. Some commodities are in greater general demand among a wide circle of potential transactors. Some commodities are more readily transportable and more easily divisible into convenient amounts to reflect agreed-upon terms of exchange. Some are relatively more durable and scarce and difficult to reproduce. The commodities that possess the right combinations of these attributes and characteristics tend to become, over a long period of time, the most widely used and readily accepted media of exchange in an expanding arena of trade and commerce.

Therefore, those commodities historically became the money-goods of the market because the very definition of a money is that commodity that is most widely used and generally accepted as a medium of exchange in a market.

Money begins as one of the ordinary commodities of the market. But because of its particular marketable qualities, it slowly comes to be demanded for its usefulness as a medium of exchange, as well. And, indeed, over time, its use as a medium of exchange may supersede its other uses as an ordinary commodity. Historically, gold and silver came to serve as the most widely accepted media of exchange - the money-goods of the market.

For Menger and later members of the Austrian school, this was a strong demonstration, both theoretically and historically, that money is not a creation or a creature of the state. In its origin, money naturally emerges out of the processes of the market, as individuals search for better and easier ways to satisfy their wants through trade and exchange.

A second question that the Austrians asked was: Once a money is in use, how does one define its purchasing power or value in the market? First Menger and then Ludwig von Mises, in his book The Theory of Money and Credit (1912; 2nd ed., 1924), devoted careful attention to this question.

In a state of barter, when every commodity directly trades for all the others, each good on the market has as many prices as goods against which it exchanges. But in a money-using economy, goods no longer trade directly one for the other. Instead, each good is first sold for money, and then with the money earned from selling commodities, individuals turn around and purchase other goods they wish to buy. Each good comes to have only one price on the market - its money price.

But money remains the one exception to this. Money is the one commodity that continues to trade directly for all the other goods offered on the market. As a result, money has no single price. Rather, money has as many prices as goods with which it trades on the market. The purchasing power of money, therefore, is the array or set of exchange ratios between money and each of the other goods against which it trades. And the actual value of money at any moment in time is that set of specific exchange ratios that have emerged on the market through the trading of money for each of those other goods in the economy.

By definition, the purchasing power or value of money is always subject to change. Anything that changes people's willingness and ability to sell goods for money or to sell money for goods will modify the exchange ratios between money and goods. If people have a change in their preferences such that they now want to consume more chicken and less hamburger, the demand for chicken on the market would rise and the demand for hamburger would fall. This would change the relative price between chicken and hamburger, as the price of chicken tended to go up relative to the price of hamburger. But at the same time, it would also change the purchasing power or value of money, since now the money price of chicken would have increased and the money price of hamburger would have decreased. The array or set of exchange ratios between money and other goods on the market would, therefore, also now be different from what they were before.

Suppose, instead, that people had a change in their preferences and wanted to demand fewer goods and wanted to hold a larger amount of the money they earned from selling goods as an available cash balance for some future exchange purposes. The demand for goods would decrease and the demand for holding money as a cash balance would increase. The money prices of goods would tend to decline, raising the purchasing power or value of each unit of money, since at lower money prices, each unit of money would command a greater buying power over goods offered on the market.

Unless people decreased their demand for goods proportionally, at the same time that the value of money was rising, the relative prices among goods would change, as well. Why? Because if the demand for, say, chicken decreased more than the demand for hamburger, then even at the overall lower scale of money prices, the money price of chicken will have tended to decrease more than the money price of hamburger. The structure of relative prices would have changed as part of the same process that had changed the scale or level of money prices in general.

Irving Fisher's proposal, therefore, to "stabilize, or standardize, the dollar just as we have already standardized the yardstick, the pound weight, the pint cup. . . ." was built on a false analogy. (See "Monetary Central Planning and the State, Part II" in Freedom Daily, February 1997). A yardstick is a multiple of a fixed unit of measurement - an inch.

But the purchasing power or value of money is not a fixed unit of measurement. It is composed of a set of exchange ratios between money and other goods, reflecting the existing and changing valuations of the participants in the market about the desirability and their demand for various commodities relative to the attractiveness of spending money or holding it as a cash balance of a certain amount.

In The Theory of Money and Credit and his later monograph, "Monetary Stabilization and Cyclical Policy" (1928), Ludwig von Mises also challenged Irving Fisher's proposal for measuring changes in the purchasing power of money through the use of index numbers. A consumer price index, for example, is constructed by selecting a group of commodities chosen as "representative" of the normal and usual types of goods bought by an average family within a particular community. The items in this representative basket of consumer purchases are then "weighted" in terms of the relative amounts of each good in the basket that this representative family is assumed to purchase during any normal period. The prices for these goods times the relative quantities bought of each one is then defined as the cost of purchasing this representative basket of consumer items

The prices of these goods, multiplied by the fixed relative amounts assumed to be bought, are tracked over time to determine whether the cost of living for this representative consumer-family has increased or decreased. Whether or not the sum of money originally required to buy the basket at the beginning of the series is able to buy a larger, smaller, or the same basket at a later period is then taken to be a measure of the extent to which the purchasing power or value of money has increased, decreased, or stayed the same.

Mises argued that the construction of index numbers, rather than being a supposedly precise method for measuring changes in the purchasing power of money, was in fact a statistical fiction built on arbitrary assumptions. The first of these arbitrary assumptions concerned the selection of goods to include in the basket and the relative weights to assign to them. Preferences for goods vary considerably among individuals, including among individuals in similar income and social groups or geographic locations. Which group of goods to include, therefore, can claim no scientific precision, nor can the judgment concerning the relative quantities labeled as "representative" in the basket.

The second arbitrary assumption also concerns the "weights" assigned to the goods in the basket. It is assumed that over the periods compared, the same relative amounts purchased in the beginning period are purchased in future periods. But in the real world of actual market transactions, the relative amounts of various goods purchased are always changing. People's preferences and desires for goods are constantly open to change. Even when people's basic preferences for goods have not changed, in the real world the relative prices of various goods are changing. People tend to buy less of goods that are rising in price and more of goods decreasing in price or more of those not rising in price as much as others.

The third arbitrary assumption is that new goods are not being offered on the market and that older goods are being taken off the market. But both occurrences are common and modify the types and quantities of goods in a consumer's basket.

The fourth arbitrary assumption concerns changes in the qualities of the goods offered for sale on the market. A good that improves in quality but continues to be sold at the same price is now a cheaper good, i.e., the consumer now gets more for his money. But the index records no increase in the value of the consumer's dollar. A good may rise in price and, at the same time, be improved in its quality. But there is no exact way to determine how much of the higher price may be due to the product's being better and how much may just be due to other changes in its supply and demand conditions that have occurred at the same time.

Ludwig von Mises's conclusion, therefore, was that there is no scientific way of knowing with any precision whether and by how much the purchasing power or value of money may have changed over a given period of time. Thus, the statistical method considered by Irving Fisher to be the key for guiding monetary policy for purposes of stabilizing the price level was fundamentally and irreparably flawed.

But whether the construction and application of index numbers was flawed or not, stabilization of the price level became a guiding target for the Federal Reserve in the 1920s. And that policy became a prime ingredient for creating the imbalances in the market that resulted in the Great Depression.