Is a calapse inevitable?

I have heard several times from different people who hold Austrian views of economics that inflation of the money supply is unsustainable and creates a boom and bust cycle that worsens with each downturn. To these individuals, eventually there will be a total calapse of the market when these swings become too extreme, resulting in something like the Great Depression. Is this a common belief of Austrian economists? If so, why is it enevitable? If not, why not?

In other words, is it possible to have a slow and controlled increase in the money supply over time without having major depressions?

Solid_Choke:

 

In other words, is it possible to have a slow and controlled increase in the money supply over time without having major depressions?

I imagine that if governments allowed recessions to pass every decade or so, rather than inflating their way out of them, then an increase in the money supply with regular recessions but no great depressions is probably possible. The bigger question though, is why the hell would we want that?

Fred Furash:

I imagine that if governments allowed recessions to pass every decade or so, rather than inflating their way out of them, then an increase in the money supply with regular recessions but no great depressions is probably possible. The bigger question though, is why the hell would we want that?

Right, and the regular deflations, purges of malinvestment would definitely lead to people being a lot more cautious and educated about such cycles.

What is scary, is that the system has continued to help itself out, by adding workers, exploiting new foreign markets that will import western inflation, etc.  "They" have been able to manipulate the other variables, in an insane economic juggling act.

If the amount of inflation was kept constant, there would be no economic contraction. What creates booms and busts are the changes in policy of the central bank. When it chooses to inflate, it creates a boom. When it can no longer tolerate inflation, it creates a bust.

Solid_Choke:

is it possible to have a slow and controlled increase in the money supply over time without having major depressions?

A growing economy - more people, more activity - requires a growing money supply, just as a growing population requires a growing food supply. If it always grew at the exact amount required, monetary-caused booms and busts wouldn't happen, and there would be no price inflation nor deflation.  But that's impossible.  Even on a gold (or any other commodity) standard, the changes in supply do not completely follow instantaniously the increases or decreases in demand. Gold can be effectively withdrawn from the system - temporarily at least - by people holding on to it, and new discoveries in places where extraction costs are below the going rate can happen any time.

Secondly, fractional reserve banking can be done even in a currency backed by gold (sometimes called "fractional receipt banking" to distingusih it from FRB where the reserves are themselves fiat or credit-backed currency).  This is legitimate, beneficial, and would likely be demanded by the market so long as the currency is not coercively monopolized, the reserve level is openly made known to depositors, and convertibility is maintained. But this can lead to expansions or contractions of the supply unrelated to the expansion and contraction of the underlying gold supply.

And lastly, booms and busts can be and are caused by normal business activity.  Just as the supply of money has to match the demand, so does the supply of everything else.  Oversupply causes manufacturing to slow, causing workers to be laid off, and this circles back and further reduces demand for goods. The opposite can happen if inventories get too low, if new technologies are invented for which there is a sudden new demand, etc.  The market can adjust to these fairly well, makes it unlikely to happen across all industries sumultaneously, and has even innovated practices that, while not necessarily the intent, tend to mitigate the ability of such cycles to build on themselves, such as "just in time manufacturing".

The Federal Reserve was established to do two primary and related things.  First, it was to be the "lender of last resort", effectively a backstop against runs caused by banks too aggressively lowering their reserve fraction.  Second, it was to try to anticipate market demand for money and proactively increase or decrease the supply.

Predictably, in a coercively monopolized fiat currency and with a bank that is both isolated from market forces and designed to "protect" regular banks from market forces, it has caused more damage than it has prevented.  It has repeatedly exacerbated organic booms and busts by mis-timing its expansions and contractions. This is completely forseeable in that the Fed has less information than the markets in aggregate have - and it acts explicitly to distort the price information that is available. In addition, it quickly became politicized to the point where, rather than simply trying smooth out business cycles, it has been used to try to create booms and eliminate busts.  Instead of contracting and expanding the money supply, it has operated in two modes: expand the money supply slowly or expand it quickly.  The problem is that this creates booms all out of proportion to any normal business cycle, such as the massive housing price inflation of this decade, and so the busts are proportionally more dramatic.  And this happens against a background of continual inflation in both the money supply and prices - as we've seen with things like oil and commodities continuing to climb even though we are currently in a bust cycle.

So your answer is that we cannot avoid a boom and bust cycle entirely, but only corecive intervention and market distortion is likely to cause anything on the scale of the Great Depression - or even the recent housing and credit bubble/bust.

Solid_Choke:

is it possible to have a slow and controlled increase in the money supply over time without having major depressions?

This is the basic idea behind Monetarism, and no it doesn't work because while you can control Money Supply, you can't control or measure Money Demand or Money Velocity, which are quite sensitive to fiscal policy.

histhasthai:

A growing economy - more people, more activity - requires a growing money supply, just as a growing population requires a growing food supply.

No, money has the distinct property amongst commodities of never being finally consumed.  It's only purpose is to exchange.  Because of this, any amount of money will work for any size economy.  What you mean is that an increase in Money Demand must be matched my a proportional increase in Money Supply in order to retain a stable "Price Level" (though the term "Price Level" has its own complications when looked at via methodological individualism).

maxpot46:

No, money has the distinct property amongst commodities of never being finally consumed.  It's only purpose is to exchange.  Because of this, any amount of money will work for any size economy.  What you mean is that an increase in Money Demand must be matched my a proportional increase in Money Supply in order to retain a stable "Price Level" (though the term "Price Level" has its own complications when looked at via methodological individualism).

My understanding (which may be totally incorrect) is that artificially stablized prices (by manipulations of the money supply) distort entrepreneurial decision making.  We need high prices to communicate scarcity, profitability etc, as well as low prices to purge inefficient over investment.

Does this sound right to you Max?  I'm an amateur when it comes to economics.

liberty student:

My understanding (which may be totally incorrect) is that artificially stablized prices (by manipulations of the money supply) distort entrepreneurial decision making.  We need high prices to communicate scarcity, profitability etc, as well as low prices to purge inefficient over investment.

Does this sound right to you Max?  I'm an amateur when it comes to economics.

Pretty much.  Without correct prices to guide them, entreprenuers make malinvestments that both cause the boom/bust cycle and also a reduction in the overall amount of available goods (and thus the overall standard of living).

maxpot46:

No, money has the distinct property amongst commodities of never being finally consumed.

So does water, but you wouldn't argue that one household's supply of water is sufficient for a whole town.  Money is neveri finally consumed, but it also does not have infinite velocity, nor is hard money infinitely divisible as a practical matter.  Just as the water in your pipes, in your toilet tank, in storage tanks, or anywhere else en route from the supply back to the supply is out of circulation, money is taken temporarily out of circulation just by virtue of it being used.  As more an more people use the same fixed amount of money, and necessarily hold it for even tiny periods of time, the less there is in circulation per person. 

Now you could argue that the only result would be falling prices, and even that such a situation might be managable, but it hits a limit when, for instance, a loaf of bread costs one one billionth of an ounce of silver.  Even if you could divide an ounce reliably into billionths, handling and exchanging such quantities is subject to massive inefficiencies - either from measurement errors or from the cost of high precision equipment and methods to avoid them. And try finding that hundred-billionths of an ounce you dropped on the floor while trying to take it out of your pocket.

Some of that could be relived by dealing with currency instead of the metal, and reconciling physical transfers into managable quantities, but that only relieves a subset of the problems. Or, you could use less precious metals for such things, but that is only a temporary fix until even they become so dear that you have to start dealing in microscopic amounts.  In addition, the less precious metals have more competing uses that make demand fluctuations for non-monetary reasons more likely and more severe.

And that is aside from any inefficiencies and distortions caused by the regularly falling prices themselves, which are numerous and potentially devastating.

histhasthai:

Now you could argue that the only result would be falling prices,

Correct.

histhasthai:

but it hits a limit when, for instance, a loaf of bread costs one one billionth of an ounce of silver.

Incorrect.  There is no such limit on silver, because if there was, it would not have been chosen as money.  Gold and silver are the best money precisely because they have the properties best suited for it, including being distributed amongst the planet's crust in such abundance such that they hold their values remarkably well against monetary demand (being readily available to find for those prospectors incentivized by the higher price that results from increased demand).

Solid_Choke:

To these individuals, eventually there will be a total calapse of the market when these swings become too extreme, resulting in something like the Great Depression. Is this a common belief of Austrian economists? If so, why is it enevitable?

It's inevitable because malinvestment involves real goods going into the hands of people who are really unproductive with them.  Correcting the situation requires getting the goods out of the hands of those people first, which requires a bankruptcy of some sort.  Mass bankruptcy of some sort = extreme recession/depression.  Look at the mortgage market -- real houses were placed in the possession of people who really can't afford them.  Getting them out of their possession and into the hands of people who really can afford them involves a messy process of foreclosure and resale at a lower (less inflated) price.  The more malinvestment, the more extreme the correction

And that is aside from any inefficiencies and distortions caused by the regularly falling prices themselves, which are numerous and potentially devastating.

These being?

-Jon

maxpot46:

There is no such limit on silver

On its face, that's just a denial of reality, there's no arguing with it. What I think you mean below is that the limit is mitigated or avoided altogether by the ability to put more money into circulation:

maxpot46:

Gold and silver are the best money precisely because they have the properties best suited for it, including being distributed amongst the planet's crust in such abundance such that they hold their values remarkably well against monetary demand (being readily available to find for those prospectors incentivized by the higher price that results from increased demand).

Gold and silver are best suited, yes, but not infinitely so.  Gold or silver in the ground are not money, and are not part of the money supply until they are extracted.  That you cite the fact that there is more to be extracted seems to concede that one of the properties that makes them suitable is the ability to expand their usable supply as money in response to demand (and, importantly, not by fiat).

If you want to call the entire pool of metal still in the ground as part of the money supply, I think it is another class of error, making our disagreement on supply expansion moot.

Jon Irenicus:

And that is aside from any inefficiencies and distortions caused by the regularly falling prices themselves, which are numerous and potentially devastating.

These being?

-Jon

Fundamentally, monetary deflation (meaning money becomes more expensive in the future), if severe and persistent enough, can make any lending economically infeasible.  If the future value of money becomes high enough above the present value to offset the risk and opportunity cost of lending, nobody will lend money.

Looked at another way, the interest rate at which someone will loan money is the subjective opportunity cost of forgoing the immediate use of the money, plus a risk premium, plus the expected rate of price inflation.  Should the rate of inflation be far enough negative, it would imply a negative interest rate.  Since keeping it under the mattress pays 0%, it's a better deal than loaning it at a negative percentage.

I don't think I have to explain the ramifications to the economy of essentially all lending drying up.

Of course the market can and will correct for this imbalance.  But the primary mechanism for doing so is the pressure put on the price of money, incentivizing increased extraction, and the like. If that is not possible, the only mechanisms are greater reliance on fractional reserves - reducing the reserve along with the concomitant risk - and, if money is sufficiently politicized, extra-market mechanisms such as outright fiat.  Remove that mechanism by assuming a priori a fixed supply, and the market's ability to correct the imbalance is limited.

The Great Deflation of 1873-1896 and William Jennings Bryan's "Cross of Gold" speech provide insight into this.

histhasthai:

Of course the market can and will correct for this imbalance.  But the primary mechanism for doing so is the pressure put on the price of money, incentivizing increased extraction, and the like. If that is not possible, the only mechanisms are greater reliance on fractional reserves - reducing the reserve along with the concomitant risk - and, if money is sufficiently politicized, extra-market mechanisms such as outright fiat.  Remove that mechanism by assuming a priori a fixed supply, and the market's ability to correct the imbalance is limited.

You're basically saying government fiat may be required in order to avoid a credit crunch arising from persistent deflation.

I don't think that's correct. In a real free market, where currencies can be started up by anyone, if gold or silver become unfeasible as backings, some people will start their own currencies, with their own backings, perhaps consisting of other metals that are not as scarce.

Let's say we have several competing currencies within one geographical area. Let's call them A, and B.

A is 100% backed by gold, and has been experiencing persistant deflation of over 5% for many years. B is 100% backed by silver, and has experienced some deflation, but not as much because their market share is significantly lower than A's, and the areas of the economy using B are growing slower.

Let's say at some point in time, annual ROI falls to less than 5%, and it would require a negative interest rate for A's loanable funds. Suddenly nobody wants to save anymore, and so they switch to B. Now that more people are using B, A is not under so much pressure from economic growth anymore, and deflation slows down to below interest rates, while B is now the currency that will eventually overheat.

If both currencies overheat, in a free market, nobody is stopping anyone from starting a third, titanium-backed currency, or using any other metal. People might even try to use fractional reserve banking to cause inflation. Temporarily people may switch to such a currency due to higher nominal interest rates, bringing about relief for the other currencies, but eventually the inflation would incentivize them to move back to metal-backed currencies.

Basically I think governments aren't at all needed in this - competing currencies are.