Re: ECON: The Hangover Theory?

From: Technotranscendence (
Date: Fri Mar 23 2001 - 00:18:55 MST

On Wednesday, March 21, 2001 10:22 AM wrote:
> Well, during the possibly past boom, there have been periods where
> rational people concluded there was no inflation because the gov't
> measures don't account for quality improvements. Also, in the
> sense that, whatever the costs may be, we can obviously live with
> them, and the Fed doesn't *have* to stop inflation. A little
> inflation may be bad, but significant deflation can be catastrophic,
> as nominal interest rates can't go negative and there's no good
> way for the banking system to handle that.

I find several problems here. First off, inflation leads to lower
efficiency, so it's bad period. It distorts prices. It makes for quality
declines. Economic measures of inflation tend to underestimate the damage.
What you have to do to truly measure it would have to be to compare the
economy sans inflation to it with inflation -- not to the economy in

Next, I don't think the Fed can stop it per se. Central banks always
mismanage money because they do not have the dispersed information available
to a free market banking system. Also, they do not have the incentives to
get it right. Finally, they do have the incentive to pander to special
interests, be they politicians, the bureaucracy, the banking industry,
debtors, or what have you.

Thirdly, deflation almost never happens and there's good reason for this.
Deflation leads to unemployment, a very quick sign that something's wrong.
Deflation still has subtle and complex effects -- see Horwitz's
_Microfoundations and Macroeconomics: An Austrian Perspective_ on this --
but it's much easier to see what's wrong. To be sure, there was a major
deflationary period in US history during the Great Depression, but it's the
only one and has never been repeated. Even worldwide, the big problem is
inflation -- not deflation.

This is not to say I'm championing deflation or saying it will never ever
happen. I just think it less likely given the incentives to inflate under
the current [central] banking systems. Under a free market banking system,
there would be a disincentive for individual banks to deflate, which would
simply lead to low profits --a quick and easy to read signal that something
is wrong.

> Japan has flirted
> with that particular pickle several times recently; certainly
> short-term rates of 0.2% are going to cause their own kinds of
> costly distortions. Inflation may be acceptable insurance against that.

Not so. What is needed is not to inflate or deflate, but to avoid both.
It's sort of like you're advocating the cure for anorexia is obesity.:)

Anyhow, a free market banking system would, IMHO, be able to handle a lot of
these problems -- or, at least, do much better than central banking has
done. The timing issue would also be on its side, since it could adjust
quickly and easily to changes, as opposed to holding meetings and examining
monthly or quarterly targets. (The quick measure would be the loss or gain
of outside money in individual banks. Each bank would be able to assess
this immediately -- not after the market tanks or its clients are lined up
outside to pull their deposits.:)

> Yes, but is it significant? It's not like the gov't isn't extremely
> anyway. And what's the value of "deflation insurance"

As I mention above, both inflation and deflation have subtle and complex
effects. These effects are very important because if either flowed evenly
through the economy, regardless of the cost of government, then they would
nicely and neatly predictable. There'd still be some costs -- "shoe
leather" and "menu" costs -- but the distortions on relative prices would be
nonexistent. Every price would just rise or fall -- assuming not rigidities
(wages are usually downward right; people don't like to take pay cuts, even
when all costs are dropping:) -- at the same rate.

However, the problem with inflation and deflation is that this does not
happen. In fact, this is the essence of the problem with them -- and why
they are such a pernicious problem. To stick with inflation, if the US Fed
lowers interest rates below the natural rate, then the first to benefit from
this are often the largest banks and the largest borrowers. They
immediately are able to take advantage of the inflation. They bid up prices
for the goods and services they purchase -- supply and demand in action --
and then those they buy from also bid up prices on goods and services they
purchase and so on. Eventually, the rise in prices is seen as inflationary,
but by then the prices have already changed, wealth has already changed
hands and a different order -- and a less efficient one, since it's not back
by the real demands of market actors, but by inflationary demands rippling
through the system -- exists than before or than would have existed had the
inflation not come about.

To put it another way, the first group to benefit from inflation benefits
the most. Economic "energy" is directed toward them when it would not have
been. In effect, it's almost a form of wealth redistribution. It also
leads to lower productivity since these are not real demands effecting, but
merely monetary ones. People not in that first group are valuing their
money too highly and they don't know until after prices go up. This extends
to all subsequent groups and individuals.

This is why inflationary periods can destroy whole economies as happened
right after World War One in Weimar Germany and in many countries during the
Great Depression. These distortions are not uncovered and undone by merely
deflating and depending on how bad they are and what the monetary
authorities do (and what government policies are enacted to prevent the
necessary adjustments) they can go on for a long time. Even afterward, the
waste is not recoverable.

> >I don't know enough about the Japanese example, though I think there
> >problems with government intervention there, including a long period of
> >inflation, price rigidities (set by law), and massive subsidies.
> No, yes, yes. Low inflation for ages.

The figures I've seen have actually shown a high rate of inflation coupled
with a high savings rate, given that savings were not taxed until the late

> Lots of detrimental gov't intervention;
> besides what you mention, land use distortion, corruption, stock price
> propping, and vast waste. It's scary that in just a decade Japan went
> from being the most solvent gov't in the West to one where default
> comes under consideration. They borrowed and spent *trillions* to
> stimulate the economy, with minimal benefit. Exhibit A against
> Keynesianism.

Agreed on that last statement, though all of economic history seems a
collection of exhibits against Keynes, Keynesianism, and the New


Daniel Ust

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