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Stable Money: Myth and Reality

August 25, 2005

What constitutes stable money? Most people today would likely say that money is stable if the price level of a given basket of consumer goods and services remains constant over time, or at least rises no more than around 2% on an annual basis. Such an interpretation would echo what central banks — today's monopoly suppliers of government paper money — have promised to deliver: in line with Irving Fisher's (1867-1947) concept of an "index number standard," central banks aim to preserve the value of money by keeping the annual rise of a consumer price index at a low and stable level over time.[1]

Fisher's approach was designed to make the US dollar one of constant purchasing power and not one of a constant amount (weight) of gold or anything else. For Ludwig von Mises — a fervent supporter of the gold standard and not impressed by theoretical fashions and fads of the day — the very idea of rendering the purchasing power of money stable did not originate from endeavors to make the crucial role of money, namely economic calculation, more correct but to do justice to the idea of "stabilization": "Shortcomings in the governments' handling of monetary matters and the disastrous consequences of policies aimed at lowering the rate of interest and at encouraging business activities through credit expansion gave birth to the ideas which finally generated the slogan "stabilization."[2]

Mises was critical of Fisher's index number concept primarily because of the notion of the "human urge towards action" — the very nature of human action — which implies incessant change.[3] "In the actual world of change, there are no fixed points, dimensions, or relations which could serve as a standard."[4] More specifically, Mises explained: "The pretentious solemnity which statisticians and statistical bureaus display in computing indexes of purchasing power and cost of living is out of place. These index numbers are at best rather crude and inaccurate illustrations of changes which have occurred."[5]

Mises conceded, however, that the index number concept, notwithstanding its serious conceptual shortcomings, could play a crucial role in the process of an economy's price movement as it would make the people inflation-conscious. He believed that once the use of inflation index numbers became common, it would force the government to slow down the inflation pace to make the people believe that the inflationary policy is merely "a temporary expedient for the duration of a passing emergency, one that will stop before long."[6] 

Today, index targeting is widely viewed as a state-of-the-art concept, and criticism has largely been confined to the issue of the choice of the actual index. In a much observed paper, Alchian and Klein (1973) argue that the price index targeted by monetary policy should not only include the prices of consumption goods and services but those of assets as well.[7] They contend that a theoretically correct measure of inflation is the change in the price of a given level of utility, which, in addition to currently produced goods prices, also includes the present value of future consumption. To capture the price of future consumption, Alchian and Klein contend that monetary authorities should target a price index that includes asset prices. Bryan, Cecchetti, and O'Sullivan (2002), for instance, concur, arguing that because it omits asset prices (especially housing prices), the US consumer price index seriously understated the loss of purchasing power during the 1990s.[8]

The point made by Alchian and Klein would gain in importance if the development of the consumer price index and that other prices in the economy, notably those of assets such as, for instance, real estate, housing, stocks and bonds, etc, would not exhibit a reliable relationship over time; that is to say if a given rise in the consumer price index is not a proper indication of what is happening to asset prices and therefore to the economy's total price level.[9] This is because in an extreme case, changes in consumer and asset prices could completely decouple (at least for a certain period to time). So even in a situation in which consumer price inflation is modest, this finding does not necessarily suggest that the purchasing power of money is preserved: "Asset price inflation" — the excessive rise in the prices of the economy's stock of wealth — could actually lead to a rise in the economy's total price level.

The latter issue, if observed in practice, would have a direct impact for money holders. Rising asset prices that are not compensated for by declining prices of goods and services would simply imply inflation, an erosion of the purchasing power of money. In fact, asset price inflation is by no means less destructive for the value of money than "traditional" consumer price inflation. Interestingly enough, however, central banks and the public at large have remained relatively relaxed about the issue of asset price inflation.[10]

While there would be nothing wrong with, for instance, (strongly) rising stock and/or housing prices over time, to preserve the purchasing power of money under the index standard, such price increases would have to be accompanied by proportional declines of other prices to keep the economy's total price level unchanged. If this were not the case, the outcome would be a debasement of the purchasing power of money.  

To take a brief look at the data, Figure 1 shows the development of the consumer price indices, long-term bond prices and stock prices in the US, Japan, Germany and the UK from the beginning of the 1980 to July 2005. With the exception of Japan, in all economies stock prices exhibited, on average, the strongest rise exceeding the increase in consumer prices by quite a wide margin. Whereas in the US and the UK bond prices rose more or less in line with consumer prices, they outstripped the increase of the cost of living indices in Japan and Germany.

These, admittedly incomplete, snapshots might well suggest that in the countries reviewed the "real" erosion of the purchasing power of money could be (much) greater than indicated by changes in consumer prices alone. If this supposition holds true, however, holding money could be economically unwise if the motive is to store up wealth: It would even end in painful real wealth losses for money holders if the interest rate paid on balances does not make up for the rise in the economy's total price level.[11]

Figure 1: Consumer and selected asset prices in the US, Japan, Germany and the UK, 1980 — 2005

Source: Thomson Financial; own estimates. — January 1980 (which is indexed to 100) to June 2005; Japan January 1984 is indexed to 100. All values in natural logarithm. — Bond prices indices represent 10-year government bonds. — Stock price indices represent broadly defined market capitalization indices.  

How can inflation, once it has gained momentum, be stopped? Friedrich August von Hayek was well aware why this would be a difficult task: inflation "is particularly dangerous because the harmful aftereffects of even small doses of inflation can be staved off only by larger doses of inflation. Once it has continued for some time, even the prevention of further acceleration will create a situation in which it will be very difficult to avoid a spontaneous deflation. Once certain activities that have become extended can be maintained only by continued inflation, their simultaneous discontinuation may well produce that vicious and rightly feared process in which the decline of some incomes leads to the decline of other incomes, and so forth."[12]

Indeed, peoples' experience with the workings of the world financial system in the last decade(s) could make it quite a challenge to end an inflationary path, once it has started. Rising asset prices such as stocks, government and corporate bonds, and housing have become a characteristic feature of international markets. Mainstream economists argue that rising asset prices represent a "wealth effect," making these price increases welcome: people would feel richer, thereby increasing consumption and investment spending, fostering economic growth and employment. This is, of course, a false conjecture: whereas holders of assets that are subject to price increase would indeed become richer, those holding money would be stripped of wealth to the same extent. As such, asset price inflation — like "traditional" consumer price inflation — does not make society richer, especially not when the negative effects of inflation on growth and employment are taken into account.

In the financial industry, for instance, rising asset prices usually entail extensive investment in technical equipment and human capital. As a result, companies could all too easily develop a vested interest in the continuation of rising prices and would likely oppose a change in the course of things. No less important in this context, time series properties of financial asset prices form the basis of risk management tools and strategies of major financial market players — such as banks, insurance companies, mutual and hedge fund managers, and also industrial companies — making the health of the industry effectively dependent on the continuation of the inflation path seen in the past.

A deliberately orchestrated "structural break" with inflation by monetary policy — that is, reigning in money and credit expansion with the objective of preserving the purchasing power of money — might therefore be likely to meet fierce opposition from various quarters. Ending an inflationary policy, if it is not perceived by the public as a necessary measure to stop an unhealthy and unsustainable development, would amount to a blow to socially powerful interest groups. On top of that, it might require substantial adjustment costs in various industries, potentially leading to temporary losses in output and employment.  

Orchestrating such a change in monetary policy is all the more challenging as central bankers — due to government and public opinion pressure — have become increasingly sensitive towards (short term) changes in the business cycle rather than securing the very conditions for preserving the purchasing power of money in the long run: "The manner in which inflation operates explains why it is so difficult to resist when policy mainly concerns itself with particular situations rather with general conditions and with short term rather than long-term problems. It is usually the easy way out of any temporary difficulties for both government and private business."[13]

But, as Mises outlined convincingly, inflation cannot continue forever. He put it succinctly: "But then finally the masses wake up. They become suddenly aware of the fact that inflation is a deliberate policy and will go on endlessly. A breakdown occurs. The crack-up boom appears. Everybody is anxious to swap his money against "real" goods, no matter whether he needs them or not, no matter how much money he has to pay for them. Within a very short time, within a few weeks or even days, the things which were used as money are no longer used as media of exchange. They become scrap paper. Nobody wants to give away anything against them."[14]

To preserve the purchasing power of money under the index number concept, preliminary evidence suggests that monetary policy can no longer define price stability on the basis of a consumer price index alone. Central banks will have to take into account asset prices — at least as long as monetary policy cannot be sure that the former is a proper indication for the latter. Latest attempts on the part of central banks, namely having started discussing and researching the issue of asset price inflation, have therefore to be welcomed.[15]

What remains unsolved even then, however, is the fact outlined by Mises on numerous occasions that money is not neutral. Therefore monetary expansion will distort the structure of relative prices — even if a price index does not change — and might thus precipitate crisis. The bottom line of it all is that the growth of money and credit, so far generously handed out by the world's major central banks and considered as the appropriate policy, have to be reduced substantially — or, as the Austrian School of economics demands — stopped altogether if the purchasing power of money shall be preserved. For the benefit of the people, stable money has to become and remain a reality rather than a myth — despite the adjustment costs for ending an unsustainable practice

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Thorsten Polleit, Honorary Professor at HfB Business School of Finance & Management, Frankfurt, e-mail: thorsten.polleit@barcap.com. Comment on the blog.



[1] The policy of price stabilization, carried out today by central banks all over the world, is mostly based on work done by Fisher between 1895 and 1922, when his The Making of Index Numbers was first published. See Formaini, R. L., Irving Fisher, Origins of Modern Central Bank Policy, in: Economic Insights, Federal Reserve Bank of Dallas, Vol. 10, No. 1 (www.dallasfed.org/research/ei/ei9601.pdf).

[2] Mises, L. von (1996), Human Action, 4th Edition, Fox & Wilkes, p. 219.

[3] "The fact that rigidity in the monetary unit's purchasing power is unthinkable and unrealizable does not impair the methods of economic calculation. What economic calculation requires is a monetary system whose functioning is not sabotaged by government interference. (…) For the sake of economic calculation all that is needed is to avoid great and abrupt fluctuations in the supply of money." Mises, L. von (1996), pp. 223-4. Back in 1928, Mises wrote a full analysis of Irving Fisher's monetary reforms (On the Manipulation of Money and Credit), concluding: "because of the imperfection of the index number, these calculations would necessarily lead in time to errors of very considerable proportions."

[4] Mises, L. von (1996), pp. 222.

[5] Mises, L. von (1996), p. 222. He explains: "In periods of slow alterations in the relation between the supply of and the demand for money they do not convey any information at all. In periods of inflation and consequently of sharp price changes they provide a rough image of events which every individual experiences in his daily life."

[6] Mises, L. von (1981, 1912), The Theory of Money and Credit, Liberty Fund, Indianapolis, p. 460; also see p. 222.

[7] See Alchian, A. A., Klein, B. (1973), On a Correct Measure of Inflation, in: Journal of Money, Credit, and Banking, February, 5 (1, Part 1), pp. 173-191.

[8] See Bryan, M. F., Cecchetti, S. G., O'Sullivan, R. (2002), Asset Prices in the Measurement of Inflation, NBER Working Paper No. 8700, National Bureau of Economic Research, January.

[9] Technically speaking this would imply that asset price and consumer price levels would not be "cointegrated" over time, or wouldn't be so over relatively short period of times in which monetary policy decisions are being made.

[10] The heterodox view is neatly summarised by Crockett (2003; italics in original): "(I)n a monetary regime in which the central bank's operational objective is expressed exclusively in terms of short-term inflation, there may be insufficient protection against the build up of financial imbalances that lies at the root of much of the financial instability we observe. This could be so if the focus on short-term inflation control meant that the authorities did not tighten monetary policy sufficiently pre-emptively to lean against excessive credit expansion and asset price increases. In jargon, if the monetary policy reaction function does not incorporate financial imbalances, the monetary anchor may fail to deliver financial stability." Crockett, A. (2003), International standard setting in financial supervision, Institute of Economic Affairs Lecture, Cass Business School, London, 5 February.

[11] During the last economic downturn in the US and the euro area, for instance, the level of short-term interest rates were lower than the annual rise in consumer inflation. This alone (that is disregarding the rise in other prices) has imposed a negative real yield on money balances, having effected a loss in the value of money holdings. 

[12] Hayek, F. A. von (1960), The Constitution of Liberty, p. 332.

[13] Ibid, pp. 332-3.

[14] Mises, L. von (1996), p. 428.

[15] In this context see, for instance, European Central Bank (2005), Asset Price Bubble and Monetary Policy, in: ECB Monthly Bulletin, April, pp. 47-60. Also, Trichet, J.-C. (2005), Asset price bubbles and monetary policy, Speech of the ECB President, Mas lecture, 8 June, Singapore.


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