Sowell’s Basic Economics: Deflation, Part One

Note: Though there are still a lot of errors and misrepresentations in this short section (pp. 373-378), it is not nearly as convoluted as the one on inflation. So we are going to take our time and enjoy this.

On page 373 Sowell writes, “From 1873-1896, price levels declined by 22 percent in Britain, and 32 percent in the United States … output was growing faster than the world’s gold supply. While the prices of current inputs and outputs were declining, debts specified in money terms remained the same – in effect, making mortgages and other debts more of a burden in real purchasing power terms than when these debts were incurred.”

First, it should be noted that the Western world was on the Gold Standard and the money supply was not shrinking. In other words, no deflation was occurring. Inflation and deflation, in a technical sense, refer only to the supply of money increasing or decreasing.

The most important thing about the money supply is that, ideally, it does not change. If it does change, it should neither increase nor decrease by very much, very quickly. There is no real optimal supply level. If newer techniques of production and better tools are invented which push down the costs of production and thereby put downward pressure on the prices of consumer goods, this ought not to be seen as a bad thing as it demonstrates than man is making advancements in his struggle against scarcity.

Now let us address the debt issue. Over the 23 year period from 1873-1896, prices fell by 32% in the United States. That is an average drop in price of 1.4% per year and is far more stable than 2% inflation per year that we experience today.  The fact that prices were falling and the overall purchasing power of the dollar was increasing put pressure on debtors to make extra payments toward their debts and pay them off or avoid going into debt unless it was unavoidable. Contrast that with today’s economy where the money is losing purchasing power and most people are in debt as a lifestyle. Debt is now a cultural norm. With the dollar losing its value at about 2% a year, it almost makes sense to buy everything you can on credit.

Have you heard of time preference? The basic idea is that – all things being equal – supposing there is not any interest and the values involved are perfectly stable over the allotted time, a man will prefer a good sooner rather than later. It is more desirable to have a it all now: a candy bar today rather than a candy bar tomorrow, a laptop next week rather than a laptop next month, a new car next month rather than next year. As the saying goes, “There is no time like the present.” When the value of money is decreasing the way it is now, inflation magnifies the time preference and makes it even more acute. Not only would I prefer a new car next month – heck, right this minute – but why should I hold my savings in the bank where it is losing value while I continue to save toward the future purchase of a new car? Next year a new car will be more expensive than the one on the lot today and my money will be worth less. I would rather use any savings as a down payment and take out a low interest loan to cover the rest.

On the other hand, when the money is increasing in value relative to the price of goods and services this usually has a tempering effect on time preference. The consumer will look at the car market and determine that though he might like to have a car right this minute, the wise thing is to continue saving his money. The money saved will be worth more in a year or two and the price of the new car will be even lower than it is now. 

As far as debts being more of a burden, there is some truth to this, but those already in long term debt can always refinance to more favorable terms or buckle down and pay off their debts early. 

While something in the amount of the average mortgage would be a pain in such circumstances, it would also be much easier to save and buy a home with cash, or with a greater down payment than what anyone approaches today.  Besides, a fellow locked into a mortgage in a “deflationary” economy could be said to be paying more in real terms. We should not forget that everything else he has to buy is getting cheaper.

Sowell finishes off the paragraph by saying, “Farmers were especially hard hit by declining price levels because agricultural produce declined especially sharply in price, while the things that farmers bought did not decline as much, and mortgages and other farm debts required the same amounts of money as before.”  

There is only an inkling of truth to this. You need to consider the time that separates investment from return. A man might spend money today, in 2016 prices, to buy apple trees and then have to wait 4 years before his first crop of apples appears that he will then sell at 2020 prices. In a deflationary setting the farmer may be said to lose money, but apples may have been one dollar a piece when he planted the trees and only 90 cents a piece the first year he sold his crop. The purchasing power of the 90 cents was the same when he sold as one dollar was four year earlier when he planted.  When you look at what his money would exchange for on the market from one time to the next, not much has changed.

Nevertheless, times were hard for farmers in this era and that has to do with tariffs. Tariffs were extremely high in this era, and it was these tariffs and not an appreciating dollar that put a burden on farmers. I have written on tariffs in previous posts, but I think they will get covered again as we work through this book.

See you soon.

The Importance of Psychology in Economics: JSP – April 1, 2016

So I’ve taken this blog in a little bit of a different direction. For all the fellow fans of the Jason Stapleton show, I’m still listening and I’m still going to point out where he deviates from the Austrian School. It doesn’t mean he isn’t worth listening to, he is probably the best source for news from a libertarian perspective.

At one point, about 30 minutes into Friday’s program, he begins discussing the great depression, and I think he got it all right. There would have merely been a panic as there was in 1819 were it not for the Smoot-Hawley Tariff, and the various other interventions that Jason discusses.

A few minutes into this talk, he brings up a very interesting question; one about psychology and how it has an influence, about what information we receive, how we receive it, and how that makes a difference in what decisions we make.

Jason talks about how the Federal Reserve tries to keep the markets calm and chooses every word very carefully so as not to spook the markets and that Ben Bernanke was giving positive outlooks right up until a week before the housing crash of 2008.

Besides this, he brings up a very interesting question about what Bernanke knew back in 2008. Did he know the markets were going to collapse and keep it quiet? Or, was he caught off guard?  I believe he was caught off guard. I don’t think he even realized we were in trouble until we were well into the recession.  But, that’s a question that we’ll have to try to get into later.

Back to the psychology of things, I think Jason does have sort of a point. If you are an Austrian you’re probably familiar with the master builder analogy. The entrepreneurs in a market are like a master builder, working on building a house, and the master builder believes he has X number of building materials and he is just a buzz of activity building away. Then he realizes he only has X-250 building materials, and he is going to be unable to acquire anymore.  So now, he stops building and panic ensues.  Some have modified this analogy so that the builder is drunk.   Jason gets this, except he doesn’t use the analogy of a builder, but a wounded soldier on the battlefield feeling the distorting effect of morphine. Not nearly as good. The wounded soldier isn’t producing, he isn’t dealing with limited resources, he is just lying there with injuries. Though he isn’t feeling pain that he really should be feeling so he thinks he is okay when he isn’t okay at all. The master builder is producing just like the economy. But, the entrepreneurs in the economy are being deceived by the artificially low interest rates created by fractional reserve banking and the expansionary monetary policies of the federal reserve.

Now, if we suppose that the master builder is drunk, or otherwise has his senses impaired, I think that Jason’s statement has some merit. The builder believes what he is told and keeps building in his drunken state (and yes, you can build things while drunk). But, as soon as he is told the resources are not as plentiful as he thought they were, he panics.

He is intoxicated, as it were, and can’t make out what supplies he actually has through his beer goggles, but is happy to just keep building. He is relying on the interest rates, and what information the Federal Reserve tells him to determine how much material he has to build with.

So, yes, what the people down at the fed say has an impact, but it isn’t because of psychological factors, it’s because, thanks to the actions of the Federal Reserve, the economy is wearing beer goggles and can’t see for itself and is thus dependent on what the fed says about how the economy is doing.

If, for instance, we didn’t have a Federal Reserve people wouldn’t be relying on a financial guru, but would instead look to market indicators, principally the interest rates to determine where the markets are going. Instead, because we don’t have that, the market is relying on every word that comes from the Federal Reserve Chairman.

So, it isn’t a matter of psychological factors, but simply trying to see through the distortions created by manipulations of the interest rate.

Here is an article exerted from Human Action that gives a great explanation.

And, there are two good Tom Woods episodes that discuss the boom-bust:
Episode 118 and Episode 419