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Anyhow, the classic definition of inflation AND deflation then, according to Mises, is:
In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur. Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for very long - Ludwig von Mises, The Theory of Money and Credit - Chapter 13, section 7, "Excursus: The Concepts Inflation and Deflation" pp. 272
Russell's definition further presumes the old mechanistic quantity theory of supply and demand, which ignores the doctrine of subjective valuation.
That means to say that in the way he defines inflation or deflation he forgets about the individual's role in determining the ratio between the stock of money and the stock of goods, that a human might value the goods one way today and another way tomorrow - relative to each other as well as in total. For instance, it is not necessarily true that by doubling the stock of goods while holding the money stock stable the value of money would double. It would rise, but by how much depends on many unforeseeable factors.
Russell thus simply assumes that any change in the quantitative relationship between the stock of money and goods creates an inflationary or deflationary circumstance as though it weren't supposed to change. But the fact is, that relationship is always changing not simply because the existing quantities do but primarily because these quantities are themselves changing according to the constantly changing demands of individuals... it's a requirement of the market that they do.
Put another way, changes in these quantities don't determine changes in value, and especially not proportionately as the old discredited version of the quantity theory of supply and demand would have it; rather, changes in human preferences affect changes in these quantities by expressing changes in valuation through exchange.
The subsequent unavoidable variations in the ratio are thus not "just" due to inflation or deflation. These latter concepts are solely meant to describe the effects on prices originating from the monetary side. Unfortunately, the vast majority of investors have adopted the Fed's definition (changes in the price level) which lump together all the effects on prices - monetary and real - and even then often poorly calculated.
Those effects originating on the real side (i.e. actual changes in tastes and preferences driving demand) don't need the term inflation or deflation; it only confuses matters. What economists need to understand when defining these particular concepts is the effect on prices on the money side, if only in order to deduce what is real.
In any transaction there are basically two independent valuations being made; on the one side there is the supply and demand for the consumption or capital good; on the other side there is the supply and demand for the monetary good.
Both valuations are assessed largely independently and culminate in a "price" - the final expression of all the independent valuations that go into the process up until the moment of exchange of which the value of money is only one.
The relationship between money and goods is important on almost every level except in the aggregate total relative quantities in existence at any given time, or in their definition of inflation and deflation. Too much money is any change in money supply relative to demand (for money) that affects changes in prices that don't represent real changes in total wealth but do nevertheless affect changes in the distribution of wealth.
Redistribution of Wealth via the Intervention in Prices from the Money Side
How inflation works is basically that the new money, once created, is passed along from one economic agent (individual or institution) to the next in exchange for goods, and that the variations in the value of money are made as it is passed along; that is, the devaluation of money is not uniform as one would think by trading the USd index.
If it were, the policy would have no value at all and we'd be left wondering, why do we have inflation if the price "level" doesn't matter?? It's true, the price level doesn't matter - it's the relative position of prices that determines the nature of production, and it's because the variations in money aren't uniform that it dislocates the market mechanism. In other words, through inflation the Fed basically appropriates the price function of the market to itself. The main effect an increase in money supply relative to demand has is to change prices; but it's in the way that prices change that they derive their benefit.
We depend on the market to signal what is "really" needed relative to what isn't. The influence from the monetary side is thus artificial (it mainly represents the tastes of those who get the money first; the economy's resources get misdirected to the production of those ends - too much money causes malinvestment not world overproduction).
Anyhow, instead of looking at it in terms of the new money being passed along and spent, passed along and spent, and so on, which is correct nonetheless, it is important to understand that the process of wealth redistribution (hidden taxation) relies on the effects of the inflation on the value of the money being passed along. In other words, the variations that are passed along is the mechanism of the redistribution of wealth.
So here's how it works: the first benefactors of the new money (the borrowers - government and private - as well as the banks) suddenly have more money than they know what to do with. In other words, the value of money in their eyes has already dropped because the proportion of their wealth that money comprises has increased and they don't need to keep so much of it on hand; this occurs to varying degree depending on the participant. Hence, they go out and spend it, which manifests as greater final demand, and they don't mind paying slightly higher prices because they've already acknowledged that the value of the money they're using has dropped "some."
It will drop more as it is passed along further. This process repeats itself as the new money is passed on in each transaction so that the earliest benefactors are buying goods at yesterday's prices before the money has made its way through the whole economy and completed its devaluation cycle. Those people receiving a fixed wage don't get the benefit of this increase in final demand, or money; they receive the same amount of money each month, or week, or what have you. So it's not a win-win; it's a zero sum game where the winners are closest to the front of the line.
This is how wealth is redistributed - from those earning fixed incomes, who can buy fewer goods each month as a result to those at the top of the food chain who benefit directly from their proximity next to the Fed - like the government or banking cartels, and those that do business with them.
The money is devaluing constantly even when it is rising on foreign exchange markets. But at times, the devaluation is so severe that it becomes apparent to all.
Conclusion
To sum up, neither debt service ratios nor free market forces drive credit demand. The Fed does, and henceforth it controls all manner of note issue as well. The dollar short idea cannot work because there is nothing to cause the squeeze. People aren't just going to turn frugal themselves. The Fed jumps on any excuse it can to keep the price of credit below market, and wages in this environment are ultimately destined to rise. too much money has nothing to do with the total stock of goods; it has to do with how it affects the composition of that stock of goods.
Ironically, Russell's theories are a service to the Fed to the extent they keep people from believing that there is a revolution in prices underway, and that it is unstoppable. Every day the Fed tries to convince you that prices aren't going to go up forever.
History says otherwise.
The Fed doesn't exist to fight deflation; it exists to sustain an inflation policy directed at the redistribution of incomes, both at home and abroad (through trade). As Rothbard said in the "Mystery of Banking," the Fed is the engine of inflation.
That said, if the Fed itself abandoned the boom then deflation would come. But this means driving rates up to intolerable levels, and shutting down the engine of inflation - dissolving the Fed in the end. The main thing standing before that result is the naive belief that prices won't rise forever. In Russell's case it is premised on a model that expects market retribution for the credit excess to manifest as a deflationary crunch.
But the real retribution we believe comes in what happens to value of the common medium. Any theory that infers a natural deflation as the response to too much credit and money in the absence of a gold standard is so off base it might as well be in another world. Like I've often said, you can't apply the laws of physics to human action.
The end of this state of affairs is one devaluation (debasement) after another - which again is precisely what has occurred since abandoning the gold standard - until one day people wake up and say this crap ain't money; because they realize that the policy of inflation is endless. At that point supply won't matter as much because it'll be the fall off in the demand for the Federal Reserve note that'll drive prices increasingly higher - the kind of fall off in demand that is relative to a better money: gold we would argue.
In other words, one day the market WILL demonetize the Federal Reserve Note (I didn't say the dollar). Maybe not in my lifetime, but then again maybe.
We learned that central banks cannot be heroes because the aim of their policy is an insidious method of additional taxation for which the government could not possibly find consent - this is the only reason it is pursued, since as Mises showed, methods of direct taxation could help achieve their aims better and more predictably.
We argued that a debt cycle can grow indefinitely so long as the difference between the rate demanded by the lender and the rate desired by the borrower can find middle ground, and so long as interest rates are below their natural rate. And lastly, our view is that the foreign exchange value of the dollar is far from oversold.
I've always liked Richard Russell and I hope he reads and ponders our objections to his reasoning on this subject. I'm sure that he's one of the best newsletter writers in the business. It is possible that we're wrong that the Fed is stuck in an inflation trap, and that the likelihood that the gold bull be interrupted by anything more than a deflation "scare" is almost nil. However, if we're wrong about that I would suggest it won't be due to a consumer led bust in the credit cycle - except for a temporary one perhaps; it would almost certainly involve something we've overlooked entirely.
There is no mystery here. The central bank is the engine of inflation and it will produce it until you're sick of it.
In the end gold is not an asset without liabilities; it is merely money. And unlike the Federal Reserve Note its supply is largely limited. The effects on production from the monetary side would be far less if it were money. Today the value of gold rises in price - significantly - when the market devalues the Fed's paper, or in the extreme when the market finally demonetizes it. From the policy perspective, as Mises said, people must not be allowed to believe that the policy of inflation is endless.
Such is the border between here and demonetization.
Edmond J. Bugos
The Goldenbar Report
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Canada V6B 4A1
The GoldenBar Report is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. We recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you to confirm the facts on your own before making important investment commitments.
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-- Posted Thursday, June 24 2004
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