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Free Money Against "Inflation Bias"

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Tags The FedFinancial MarketsInterventionism

11/14/2006Thorsten Polleit

Today's mainstream economics maintains that inflation — defined as an ongoing rise of the economy's price level over time — is "a prerequisite for a growing and thriving world."[1]  A great number of arguments in support of the "inflationist view" have been put forward. For instance, inflation would be needed to allow real wages and employment to adjust more smoothly to changing market conditions.

A more recent argument in favor of central banks pursuing positive "inflation targets," or at least "zero inflation targets," is the alleged necessity of preventing nominal interest rates from hitting zero.[2]  Such an outcome, it is widely feared, would run the risk of making monetary policy ineffective in terms of influencing real and nominal magnitudes.

At the same time, deflation — understood as an ongoing decline in the economy's price level — is widely believed to harm output and employment. For instance, if consumers expect goods and services to become cheaper in the future, it is feared, they would postpone their purchases, thereby setting into motion a vicious downward spiral: dropping demand, falling prices, declining output.

Taking an "outside view" by today's standards, Milton Friedman argued in the late 1960s that "optimal inflation" should be negative.[3]  Specifically, Friedman suggested that economic welfare was maximized when the nominal interest rate was zero; this requires inflation to be equal to the negative of the real interest rate (as will be explained in some more detail below).

A well-established ideological "inflation bias" couldn't be more dismissive of the idea of a central bank delivering deflation. If the price level declines, so the reasoning goes, a borrower's real debt would rise, and debt servicing would become difficult, even impossible. What is more, declining prices would make investors unwilling to lend, as money balances gain in value over time without money holders having to embark upon risky investments. In short, capital markets couldn't do their job properly if the price level declines over time.

Admittedly, the whole discussion — including the underlying definitions of the variables used therein — couldn't be more out of touch with the thinking, insights, and recommendations of the Austrian School of Economics. As Ludwig von Mises wrote:

"By committing itself to an inflationary or deflationary policy a government does not promote the public welfare, the commonweal, or the interest of the whole nation. It merely favors one or several groups of the population at the expense of other groups."[4]

Mises argued for an unconditional return to the principles of free-market money. Money as a means of exchange must be the product of unhampered market forces. Government-controlled money would violate the principle of justice and lead to economic inefficiency.[5]  It would pose insurmountable limits to human knowledge, thereby inviting fraud and causing costly, even fatal, policy errors.[6]  The money supply monopoly should be wrested from the hands of the government and returned to the free market.

Mises was particularly aware that any crisis resulting from a government-run monetary system — such as, for instance, rising unemployment following a recession and deflation, caused by the bursting of a government-sponsored credit and money expansion boom — would swing wide open the doors for government interventionism, threatening the very foundations of the free-market society.

From that viewpoint, advocating free-market money actually amounts to seeking protection against the danger of eroding societal freedom through governments. Mises put it succinctly:

"It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part governments. Ideologically it belongs in the same class with political constitutions and bills of rights."[7]

The rest of this article has two goals. First, to show that market agents' savings and investment decisions are actually indifferent towards any (a-priori known) changes in the price level; the notion of an economically necessary "inflation bias" for facilitating savings and investment can easily be discarded.

Second, to elaborate on Mises's point, namely, that when it comes to preserving the free society, deflation won't be any better than inflation under a government-run monetary system; and that the only way to reverse the path towards disaster would indeed be an unconditional return to free-market money.

To set the ball rolling, let us take a brief look at the composition of nominal market interest rates. According to the "Fisher equation," the nominal rate, can be separated into two components, that is the real interest rate, and a premium compensating for inflation (expectation), π:.

Assume, for the sake of a simple illustration, that the economy's real (trend) growth rate is 2.0% per annum (p.a.), and inflation (expectation) is ˜1.9608% p.a., which gives, according to the above formula, a nominal interest rate of 4.0% p.a.

Now let us consider saving and investing in today's inflation regime (see Fig. 1). For instance, the saver buys a bond in the amount of US$100.00 in t = 0, which has a maturity of 10 years (column 2). Starting in t = 1, the bond holder receives annual coupon payments of US$4.00 (that is the nominal interest rate of 4.0% p.a. multiplied by the principal amount of US$100.00). In t = 10, the investor receives US$104.00, that is the bond's principle plus US$4.00 interest payments.

The development of the price level is shown in column 3. It is assumed to be 100 in t = 0, and it increases in line with inflation, so that after 10 years the price level is 121.4. Column 4 shows the cash flows in real terms, that is dividing 2 by 3. Column 5 exhibits the present values of the periodical cash flows in real terms, discounted at the real interest rate to t = 0. Finally, column 6 gives the real net present value (NPV) of investment — that is the real outlay of US$100.00 in t = 0 plus the present values of future real cash flows in the amount of US$100.00.

The NPV of the investment is zero. This finding should not come as a surprise: it simply says that the internal rate of return of the investment equals the real interest rate of 2.0% p.a.[8]  To put it differently, the investor has secured a real return on his or her investment of exactly 2.0% p.a., and the borrower has gained access to funds for 20 years, for which he or she pays a real rate of 2.0% p.a.

What would happen if inflation is negative, and the nominal market interest rate zero? Consider an economy in which output is growing at a positive rate of, say 2.0% p.a. Inflation compensation, however, is now ˜ -1.9608% p.a., making the nominal market interest rate zero according to the Fisher relation. Fig. 2 shows the payments under the assumption of zero nominal market interest rates.

Again, the investor pays out US$100.00 in t = 0 and receives US$100.0 in t = 10, with no payments inbetween as coupon payments are zero (column 2). Column 3 shows the price level, which declines from 100.0 in t = 0 to 82.0 in t = 10. The cash flows in real terms are shown in column 4. The real payment at the end of the maturity of the bond amounts to US$121.90. Discounting this payment by the real interest rate yields a PV of US$100.00 in t = 0 (column 5). As a result, the NPV of the investment is zero. Again, the real return of the investment is 2.0% p.a. (column 6).

The two examples suggest that saving and investing would be possible irrespective of a rise or a fall in the price level rises over time. In both regimes savers earn a real return of 2.0% p.a., and investors pay real cost of borrowing of 2.0% p.a.

But what about periodic payments (as might be desirable for, for instance, pension related investment purposes) in a regime of zero interest rates? As can be shown, this would also be possible.

The credit contract would simply have to include a clause for the borrower to make periodic payments, which, in turn, would lower the (real) amount of principle to be paid back at the end of the maturity of the bond.

Using the example shown in Fig. 2, let us assume the borrower and lender agree for annual payments in the amount of US$2.00 in the credit contract (see Fig. 3). As a result, the investor would receive a nominal US$2.00 each year, reducing the pay-back payment in t = 10 to US$82.00 (that is US$100.00 minus nine times US$2.00). Again, the real return of the investment is 2.0% p.a.

These simple examples suggest that savers and investors can be expected, irrespective of ongoing inflation or deflation (and positive or zero market interest rates), to provide funds and demand funds, respectively. Savings and investment, therefore, would take place regardless of whether the economy's price level rises or declines over time. Against this background, no intellectually convincing case can be made for upholding the notion of an economically necessary "inflation bias."

To be sure, today's upward drifts in prices are the outcome of deliberate government "inflationist" decisions made in the past. No doubt, a change in the currently established inflation regime — that is, for instance, moving from inflation to deflation — would result in far-reaching redistribution of income as far as already outstanding contracts are concerned: borrowers would have to cope with a higher-than-expected real capital costs, and lenders would enjoy a higher-than-expected real income at the expense of borrowers.

Is there any merit, from the Austrians' viewpoint, that would suggest recommending central banks to switch from an inflationary to a deflationary regime? The answer is no. As long as governments retain the money supply monopoly, the erosion of the purchasing power of money could, and presumably would, also occur under "deflation targeting": central banks — unlikely to be shielded against demands from an "inflationist public opinion" — might simply opt for deflation that is lower than the decline in the price level as expected by market agents.[9]

Perhaps most importantly, the very source of the crises would remain in place: the concept of "price index targeting," which rests on the erroneous "stabilization" idea, a concept that is in full contradiction to the notion of free markets: "Human action originates change. As far as there is human action there is no stability, but ceaseless alteration."[10]

In view of changes in the money stock, Mises explained that "[w]hat is fundamental to economic theory is that there is no constant relation between changes in the quantity of money and in prices. Changes in the supply of money affect individual prices and wages in different ways. The metaphor of the term price level is misleading."[11]

For the Austrians, government-induced change in the stock of credit and money — be it for the purpose of delivering inflation or deflation according to pre-determined designs — must inevitably result in a distortion of relative prices, lead to a misallocation of scarce resources and, ultimately, pave the way towards crisis.

What is more, if a central bank, under deflation targeting, reduces credit and money supply less rigorously, the economic outcome would be equal to a situation in which the central bank, under inflation targeting, expands credit and money supply too generously. In both cases real credit and money supply would increase, debasing the purchasing power of money.

Even under a regime in which government controlled central banks pursue deflation targeting there would be the risk of creating unsustainable debt levels for private households, firms and governments. A rising indebtedness (relative to income), in turn, would sooner or later tip the balance of societal preference in favor of debasing the value of money.

From the Austrian point of view, a government controlled money supply system, coupled with the price level stabilization idea, is inherently crisis prone, irrespective of inflation targeting or deflation targeting. That is why Austrians argue for an unconditional return to free-market money. They see it as a solution to the dangers emerging from today's monetary regime.


[1]  Rothbard, M. N. (2006), For a New Liberty, Ludwig von Mises Institute, p. 217.

[2]  An in-depth discussion of this issue can be found, for instance, in: Johnson, K. H., Small, D., Tryon, R. (1999), "Monetary policy and price stability," in: Austrian Central Bank, 27. Volkswirtschaftliche Tagung, pp. 65–94, in particular pp. 81.

[3]  See Friedman, M. (1969), "The Optimum Quantity of Money," in: Friedman, M. (ed.), The Optimum Quantity of Money and other Essays, Aldine, Chicago, Il.

[4]  Mises, Ludwig von, Human Action, Chapter 17, section 18: "The Inflationist View of History."

[5]  For an insightful elaboration of this issue see, for instance, Hoppe, H.-H. (2006), The Economics and Ethics of Private Property, Ludwig von Mises Institute, pp. 175–204.

[6]  Using the term "pretense of knowledge," this point was forcefully made by F.A. Hayek in his lecture to the memory of Alfred Nobel, December 11, 1974: "The Pretense of Knowledge."

[7]  Mises, "The Principle of Sound Money," Chapter 21 of The Theory of Money and Credit.

[8]  Note that the internal rate of return of 2% is the discount rate which makes zero the difference between the present value of cash flows to be received in the future and the initial outlay.

[9]  This would be analogous to current practice, in which actual inflation is usually allowed to exceed promised inflation.

[10]  Mises, Human Action, Chapter 12, section 4: "Stabilization."

[11]  Mises, "The Non-Neutrality of Money," in: Money, Method, and the Market Process.


Thorsten Polleit

Dr. Thorsten Polleit is Chief Economist of Degussa and Honorary Professor at the University of Bayreuth. He also acts as an investment advisor.

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