Anthony Davian's  Instablog

By: David Stone

SeekingAlpha.com recently had a very interesting article titled The Unsustainable Lie of Inflation. Paco Ahlgren writes compellingly about propaganda in the context of inflation. The “Big Lie” is that national economic policy promotes inflation with the motive of seducing consumers to believe that their possessions are worth more. The authors panacea for the “Big Lie” is abandonment from fiat currency and return to a gold/metal standard.

Interestingly, in a former life, Alan Greenspan was a gold bug and lays out a few bullet-points on how this could be accomplished in a September 1, 1981 article titled Can the U.S Return to the Gold Standard? It was essential reading as my primary question wasn't why but how. Greenspan v1.0 writes that a scaled in plan using gold-redeemable Treasury Notes is how you would accomplish such a thing.

Humorously he also writes “A commission to study the issue, with strong support from President Reagan, is in place.” I assume the strong support faded when Reagan realized a GS would force him to actually be fiscally prudent and not just talk about it. The politically agile Greenspan dropped Objectivist as his middle name and the rest is history. Greenspan v2.0 never saw inflation he couldn't fight with an interest-rate hike.

Greenspan writes immediately after a period of social, economic, and political unrest. The Vietnam Era subsided into the Oil Embargo and double digit inflation of the 70's. So it is easy to see how he would be looking to change a few things.

But currency is simply a medium of exchange developed long ago to facilitate trade. The lure of gold is that supply is fairly stable, availability is more or less known and it is valuable because of its scarcity and its beauty. Advocates of the GS object to the manipulation of economies by government and central banks.

The central arguments are fiat currency makes deficit spending easy, fiat currency relies heavily on governments/central banks intervention into an economy, and fiat currency is to blame for inflationary cycles. I find that these objections are more about government policy than how the gold standard would fix them.

Fiat currency does make deficit spending easy. Politicians are, always have been, and will be forever spineless. I guess it's the nature of the beast. What is funny is that many of us think that our group (which ever group one tends to identify with) is somehow more fiscally prudent than the other. I've simply accepted that they are all the same. They somehow figure a way to funnel their gross spending habits toward whichever agenda they support.  Don't worry each group finds a way to screw up and if yours isn't writing the checks today, they will be tomorrow.

Fiat currency does rely heavily on central banking to respond to economic threats. This may be seen as a distortion of free market capitalism but is it? Since Adam Smith is credited as the authoritative observer of capitalism, I will recount his thoughts. Smith knew that an economic system had to work within the confines of a stable political ones. When he wrote The Wealth of Nations, England was a true monarchy. People had to pay taxes, interest rates were set (albeit infrequently) by the crown and most people owned no land. Adam Smith did not have opinions on whether taxes or arbitrary interest rates were right or wrong. He saw them as a fact of life and observed what worked best within them.

Fiat currency may cause inflationary cycles. The last significant period of inflation was the seventies as this is what Greenspan is responding to in his editorial. In 1971 Nixon abandoned the post-WW2 Bretton Woods agreement and the U.S. said a fond farewell to the GS. The OPEC Oil Embargo soon followed and the decreasing value of the USD is at least partially to blame. So yes the last significant period of inflation occurred after the U.S. abandoned the GS. After a sweeping economic change like 1971 it would be expected that at least some turmoil would ensue and it did. Why is the GS that creates inflation of 10% one year and -2% the next better.

A cursory look at inflation data is fun because you see the big numbers jump out and try to associate them with historic periods. One thing is clear. War economies tend to red-line our currency. The most interesting year though is 1932, the nadir of the Great Depression. 1932 saw a 10.3% INCREASE in the value of our currency. It seems currency deflation is a result of economic stress also.  Ahlgren strangely argues that deflation is somehow good.

Now the word hyperinflation has also been batted around quite a bit. Hyperinflation has occurred only twice in the United States. The first time was as the continental congress tried to create a cohesive government after the Revolutionary War. The second time was in the short lived confederacy. Hyperinflation is an anomaly usually created by immature or inept political and/or economic leadership. Now if and when inflation hits 10% the media will probably call it hyperinflation because it sounds sexier but in reality it will be just plain old boring inflation. Inflation above 100% and you can call it what you want because the U.S. as we know it will most likely have ceased to exist.  Our political leadership may be inept, but hopefully it's not that inept.

A gold standard tends to make economic and political shocks acute. Instead of a somewhat gentle increases of unemployment everyone is out of work very quickly putting a snowballing sequence of stresses on the system. The money supply contracts creating bank runs and eventual closings. Financing comes to a grinding halt and further operations are effected. All this can happen virtually overnight.  At this point the only one able to clean up these catastrophic messes is guess who? Uncle Sam and usually by circumventing the GS. In the past the GS has been blamed for as much hardship as GS advocates say has been created by its abandonment. So is this really better?

But Ahlgrens chief complaint is inflation and the way he discusses it is puzzling. He seems to think people in general are confusing price with a products real value. Here is an example:

“As humanity has progressed, technology has always increased our standard of living, and created more efficiency. And this has almost always resulted in falling prices. If you don’t believe me, think about how much bananas must have cost in Norway during the 16th century. Or think about how expensive cinnamon must have been in England in the 10th century. Most people would never even see these commodities – let alone be able to pay for them. Today, bananas and cinnamon are accessible globally, to anyone, at very low costs. Technology caused them to depreciate over time – not increase in price, as your government would have you believe should have been the case. Or how about the most contemporary – and perhaps best example of all: the computer industry, and Moore’s Law. Prices of computers don’t increase over time -- they decrease with obsolescence and improved technology.”

The use of computer prices and banana prices and Moore's Law as  deflationary examples is troublesome. Yes the prices of bananas and computers have decreased tremendously in the past twenty years but the value of the banana is nothing once it is eaten and a computer can only function properly as long as the technology is relevant. The computer prices rapid falling is not deflationary, it is technological and market driven. Ahlgren seems to confuse this.

He goes on to say:

“In theory, it’s a great idea. You buy stuff, the Fed keeps inflation at about 3%, and in most cases, after a long period of time, your stuff seems more valuable. You can boast to your friends at work and at parties, 'I bought my house for $50,000 in 1977, and today it’s worth $200,000! I’ve quadrupled my money!'”

In the above paragraph he contends that people are confusing nominal and real prices. I agree that inflation is the primary reason that the house is now $200,000 but it is also the primary reason that that same person made $5000 per year when he bought the house and $40,000 per year when he retired. The houses real value never really changed. Comparing a computers falling price with a houses increasing price doesn't make any sense because the factors of time and life of product are left completely out of the equation.  If he is trying to argue that our standard of living is diminished by inflation I have open ears.  By most accounts it is falling which is indeed troubling, but is this inflationary?  If someone is not able to realize the difference between nominal and real price propaganda isn't to blame – ignorance is.

Adam Smith writes extensively on real prices in The Wealth of Nations. He observed (I think correctly) that labor is the only way to compare a products true price. A house costs $300,000 to build today because of the compounded labor costs involved in not just building the house, but creating all the products that the house is made up of with a nominal amount of profit margin for the many business interests in the complex chain of production. At $20 per hour this hypothetical house takes 15,000 man-hours to complete. The same equation would hold true of the computer and bananas. He even writes about the cost of gold in this context with much of it being the military costs of subduing a local population in gold-rich foreign colonies. It is a simple but effective way to gain perspective on the riddle of price.

My opinion is that the call to return to the GS is largely about anti-government sentiment and government spending than about the benefits of the GS. Do GS advocates have a firm grasp of the consequences of a GS as well as the benefits? Our economy has been shown to tolerate mild to significant periods of inflation fairly well. Arguments can be made on both sides of issue and even I am sometimes drawn to the romantic notion that the GS would be a return to a simpler, better time.

The hard truth is that fears of real hyperinflation are unwarranted because if the U.S. ever reaches that point we will all be worried about more important things than our purchasing power. It will be guns and butter time baby!

Would a government that has been unable to keep its checkbook balanced stick to the intent of a GS when several times in U.S. History gold redemptions were summarily abandoned. Post-1929 FDR even went so far as to outlaw the possession of gold specie.

Ahlgren thinks otherwise and while cutting a decent argument, the hyperbolic propaganda quotes leave me hollow. Yes those things were said but context is everything. The Keynes quote at the beginning of the article was actually a call to curb inflation. I guess the current economic climate makes a ready villain out of all though. That and the idea that anything is better than this. I'm not so sure!

Disclosure: none