by
William L. Anderson

Recently
by William L. Anderson: Paul
Krugman and Zombie Financial History

Your points
in the November
29 column on Paul Krugman and the Austrians makes good points,
and I would like to make a few comments of my own.

I do believe
that when one makes apocalyptic comments, one gets what he deserves
if the predictions don’t pan out. As you said, that does not mean
the Austrians are wrong regarding money and inflation, but expansions
of money, especially in the way that the Fed has gone about doing
so, are going to have a number of effects, rising consumer prices
being only one of them.

I also believe
that some of the Austrians, when they predicted near-instant hyperinflation,
should have known better. An expansion in the monetary base can
lead to what Milton Friedman called the “pushing on a string” effect,
as an expansion of bank reserves will not increase the amount of
money in circulation (at least not significantly) if businesses
and individuals are not borrowing.

This is not
to say that the Law of Marginal Utility, as applied to money, is
somehow invalidated. An expansion of money in circulation will mean
that the value of the marginal unit – in this case, the dollar –
will fall, which means more money will be necessary to complete
monetary transactions. That is the straight Law of Marginal Utility,
and it applies to money as much as it would to anything else that
is scarce.

As Murray Rothbard
points out in his book, America’s
Great Depression, the amount of money in circulation during
the 1920s grew, and he terms that as “inflation.” However, according
to the Consumer Price Index of that time, consumer prices fell by
roughly one percent a year, which the late Jude Wanniski used as
“proof” that Rothbard was wrong when he claimed that the 20s was
an inflationary period. What we witnessed was an apples-and-oranges
kind of comparison, as most people (including most economists) generally
are used to defining inflation as an increase in the government’s
CPI, but the Austrians would say that changes in the CPI would be
the result of inflation and in our case, the result of the
monetary policies of the Fed.

While both
Austrians and the Monetarists would see inflation as a monetary
phenomenon where changes in relative prices of goods and services
occur because the value of money, which is used to denote those
relative price relationships, changes as the supply expands and
contracts. The Austrians take one step further, however, as they
go beyond the quantity effects of increases in the amount of money
and look at how these monetary increases change the relative prices
of real goods. In other words, the significant effect of changing
the amount of money in circulation is not necessarily the changes
in consumer prices (although they will change over time relative
to the money in circulation), but rather the effect that monetary
changes will have upon the relationships of the value of real goods
to each other.

This point
is vital, for the Austrians hold in their business cycle theory
that when the central bank manipulates the banking system to increase
the amount of money in circulation, the larger effect is not in
consumer price changes but rather the fact that relative values
of real goods are changed in a way that directs longer-term investment
into lines of production that would seem to be profitable but over
time turn out not to be. We certainly saw that in the housing boom
and in the tech boom a decade earlier. Investments were directed
into production lines that could not be sustained, given the preferences
of consumers and their own financial constraints.

In the meantime,
the actions of the central bank, when added to various policy initiatives
by government, can create these booms that are unsustainable within
a market setting and sooner or later are exposed by the markets
themselves. When the meltdown became absolutely apparent in September
2008, we were seeing a situation where the market was declaring
the mortgage securities held by Wall Street firms to be near-worthless.

(I would like
to add a separate point here. Why is it that when a firm tries to
manipulate the market to make an asset look more valuable than the
market would say it is, authorities view that as being illegal,
but when the Fed does it, as it is doing with its QE policies, that
is considered “good for the economy”? After all, by purchasing billions
of dollars of mortgage securities, the Fed is manipulating their
values, given that the sheer purpose of Ben Bernanke’s actions is
to artificially raise security prices, which is deemed criminal
behavior if a private firm does it.)

Krugman has
explained that these bubbles were due to nothing more than the failures
of private markets, and that unless government regulators intervene,
markets always will go over the cliff because, well, because markets
are just like that. Yet, if one holds that price signals really
do matter, then one would ask why all markets do not behave in the
manner we saw. Why not an automobile bubble or a bubble gum bubble
or a firewood bubble? Instead, Krugman wants to absolve the Fed,
Freddie and Fannie, and the various government agencies that were
pushing home ownership and refinancing through policies of having
played any part whatsoever in the housing bubble, as he wants us
to believe that the problems were due solely to what he and other
Keynesians believe to be the inherent failures that automatically
accompany market transactions.

Austrians,
on the other hand, look for the cause-and-effect. Carl Menger, the
original Austrian Economist, begins his classic 1871 Principles
of Economics with: “ALL THINGS ARE SUBJECT to the law of
cause and effect. This great principle knows no exception, and we
would search in vain in the realm of experience for an example to
the contrary.” Why the “irrational exuberance?” Krugman holds to
the Keynesian line of “animal spirits” of investors, but that is
no cause at all. Why shouldn’t “animal spirits” bid down the values?
Do they believe that investors are irrational when bidding up
asset prices, but are rational when bidding them down? The
Austrians would say that Fed policies of driving down interest rates
where they would greatly affect mortgage markets, along with the
drive-people-into-home-ownership policies of the Federal government
created huge incentives for the creation of the housing boom, which
ultimately turned into a bubble, and then a huge bust.

Regarding the
consumer price effects of the Fed’s policy of spreading dollars
around the world, we can see some price increases in various commodities,
i.e. food and fuel. Those of us who purchase gasoline or go to the
grocery story can attest to some very large price increases over
the past five years, and farmers where I live tell me they are having
to absorb large increases in the price of animal feed, fertilizer,
and diesel fuel. While Krugman wants to explain away these changes
as being driven purely by inherent “volatility” and economic growth
in places like China, it would seem to me that large increases in
the money prices of those things denominated worldwide in dollars
just might be due to large increases in the amount of money being
poured into these assets and lines of production.

There
is one more point. The Fed has vastly increased its balance sheet
and has been spreading dollars around the world, mostly to purchase
“assets” that essentially have little or no value so that the holders
of those assets do not have to take the necessary financial bath.
Such actions would not necessarily result in a huge increases of
consumer prices overall, but they would have the effect of directing
real investment away from those lines of production that would be
both profitable and sustainable. Whether it is protecting
the banks or the “green investors” or governments that have spent
themselves into financial oblivion, the Fed has stymied the recovery
by forcing assets into production areas that are doomed to failure.
The result is what we see around is in the anemic economic growth.

Where some
of the Austrians went wrong was in assuming that all of the
Fed’s new money pumping would be channeled into the purchase of
consumer goods, thus driving up their prices. We have to look at
where the new money is going, not where we might think it
is going.

February
26, 2013

William
L. Anderson, Ph.D. [send him
mail], teaches economics at Frostburg State University in Maryland,
and is an adjunct scholar of the Ludwig
von Mises Institute. He
also is a consultant with American Economic Services. Visit
his blog.

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© 2013 by LewRockwell.com. Permission to reprint in whole or in
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