| | Is deflation such a problem that the government must engage in a massive increases in the money supply in order to offset it? Not according to the late Austrian Economist Murray Rothbard. In his book A History of Money and Banking in the United States, Rothbard comments on the massive deflation that occurred in the U.S. from 1839 to 1843. During that period, he tells us, unsound banks were eliminated and unsound investments liquidated. "The number of banks during these four years fell by 23 percent. The money supply fell from $240 million at the beginning of 1839 to $158 million in 1843, a seemingly cataclysmic drop of 34 percent, or 8.5 percent per annum. Prices fell even further, from 125 in February 1839 to 67 in March 1843, a tremendous drop of 42 percent, or 10.5 percent per year. . . ." (p. 101)
He then asks: "But didn't the massive deflation have catastrophic effects -- on production, trade, and employment, as we have been led to believe? In a fascinating analysis and comparison with the deflation of 1929-1933 a century later, Professor [Peter] Temin shows that the percentage of deflation over the comparable four years (1839-1843 and 1929-1933) was almost the same. Yet the effects on real production of the two deflations were very different. Whereas in 1929-1933, real gross investment fell catastrophically by 91 percent, real consumption by 19 percent, and real GNP by 30 percent; in 1839-1843, investment fell by 23 percent, but real consumption increased by 21 percent and real GNP by 16 percent. The interesting problem is to account for the enormous fall in production and consumption in the 1930s, as contrasted to the rise in production and consumption in the 1840s. It seems that only the initial months of the contraction worked a hardship on the American public and that most of the earlier deflation was a period of economic growth. Temin properly suggests that the reason can be found in the downward flexibility of prices in the nineteenth century, so that massive monetary contraction would lower prices but not particularly cripple the world of real production or standards of living. In contrast, in the 1930s government placed massive roadblocks on the downward fall of prices and wage rates and hence brought about severe and continuing depression of production and living standards." (pp. 103-104)
Consider the depression of 1920-1921 in which there was no stimulative government policy. The depression was over very quickly, because prices were allowed to fall to levels that could sustain economic activity. Moreover, it is instructive to compare the U.S. response to the 1920-21 depression with that of Japan, which embarked on a planned economy in order to keep prices up. In his book Economics and the Public Welfare, Benjamin Anderson describes the Japanese policy as follows: "The great banks, the concentrated industries, and the government got together, destroyed the freedom of the markets, arrested the decline in commodity prices, and held the Japanese price level high above the receding world level for seven years. During these years Japan endured chronic industrial stagnation and at the end, in 1927, she had a banking crisis of such severity that many great branch bank systems went down, as well as many industries. It was a stupid policy. In the effort to avert losses on inventory representing one year's production, Japan lost seven years, only to incur exaggerated losses at the end. The New Deal began in Japan in early 1920 -- a planned economy under government direction designed to prevent market forces from operating and, above all, designed to protect the general price level. (75-76)
By contrast, Anderson observes, "in 1920-1921, we [the U.S.] took our losses, we readjusted our financial structure, we endured our depression, and in August 1921 we started up again. By the spring of 1923 we had reached new highs in industrial production and we had labor shortages in many lines. (Emphasis added)
"The rally in business production and employment that started in August 1921 was soundly based on a drastic cleaning up of credit weakness, a drastic reduction in the costs of production, and on the free play of private enterprise. It was not based on governmental policy designed to make business good. The drop in the physical volume of production from the high of July, 1920, to the low of 1921 was drastic and was indeed unprecedented in severity, so far as records went, down to that date. The depression was, however, much less severe than that of the 1930's. This was primarily because of the very rapidity of the break in prices and the general readjustment in costs. On the basis of the Federal Reserve Index of Production (which has as its base the average for the years 1923-1925) the physical volume of production dropped from 89 in July, 1920, to 65 in July of 1921. Then the Index of Production began to rise. Moderate improvement began August of 1921. Through 1922 there was strong improvement and by March of 1923 the Index of Production had risen to the radical new high of 103, and it rose further to 106 in April of 1923." (76-77)
Seven decades later, during the 1990's, the Japanese government made the same mistake they made in addressing the depression of 1920. They launched the very programs that the Obama administration is now touting as the solution to our own recession/depression. As Thomas E. Woods, Jr. points out in his best-selling book Meltdown, they introduced no less than 10 fiscal stimulus packages at a total cost of over 100 trillion yen, none of which worked. "In addition to keeping the Japanese economy in the doldrums, these packages also put Japan in terrible fiscal shape, with its national debt (including various kinds of 'off-budget' debt) in excess of 200 percent of GDP. In order to get banks lending again, the Bank of Japan pumped money into the banking system at an extraordinary rate between 2001 and 2003 -- in April 2002, the yearly rate of growth was 293 percent. It didn't work. During those years bank loans averaged a 4.5 percent annual decrease. All these activities distort market processes and hinder the reallocation of resources that needs to occur as a boom comes to an end and a bust begins to set in." (p. 83)
The best solution to a recession or depression is to allow the market to readjust on its own, free of government stimulus or intervention, which if history is any indication, can only make matters worse.
- Bill
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