Monetary Central Planning and the State, Part 2: The Rationale of a Stable Price Level for Economic Stability

One of the most influential economists during the first 30 years of the 20th century was Yale University professor Irving Fisher. In 1896, he published a book entitled Appreciation and Interest . He argued that price inflations and price deflations can have a disturbing effect on the relationship between debtors and creditors if the inflations and deflations are not correctly anticipated by borrowers and lenders.

The rate of interest, he explained, is the price for borrowing money and having use of the resources and commodities that a sum of money can purchase over a period of time. Lenders are willing to part with their money for the period of the loan because they receive a premium — interest — along with return of their principal. The interest represents an additional amount of purchasing power for goods and services. It is the reward for the lender’s forgoing the use of his money during the loan period.

Suppose that creditor and debtor have agreed on a rate of interest of, say, 5% for a loan covering a one-year period. Now suppose that during this one-year period, prices in general rise unexpectedly by 3%. When the loan is paid back with its 5% interest, the lender will discover that to buy the same quantity of goods that the principal of the loan had been able to purchase in the market a year earlier, he will now have to spend the principal plus 3% of his interest income. The real gain in buying power from having lent this sum of money, therefore, will not be 5%, but in fact only 2%. The unanticipated price inflation will have eroded three-fifths of the real value of his interest income.

On the other hand, imagine that a similar type of agreement is made between creditor and debtor for a 5% rate of interest on a one-year loan, but prices in general unexpectedly decline by 3% during that year. When the loan is paid off at the end of the year, the lender will discover that because of the unanticipated price deflation, the principal he lent has 3% greater purchasing power than at the beginning of the year. The real gain in buying power from the lender’s point of view, therefore, is 8%, not merely the 5% interest contracted for in the loan agreement.

In the first case — that of unexpected price inflation — the borrower will pay back his loan in depreciated dollars. The burden of his debt will be diluted because of the decline in the value of money during the period of the loan.

In the second case — unexpected price deflation — he will pay back his loan in appreciated dollars, and the burden of his debt will have been increased because of the increase in the value of money during the period of the loan.

Irving Fisher argued that if the rate of price inflation or price deflation could be correctly anticipated by the transactors to the loan agreement, then neither creditor nor debtor would gain or lose during the period of the loan. Why? Because knowing that money would either lose or gain some given percentage in purchasing power over this period of time, borrowers and lenders would adjust the terms of the loan to reflect the expected change in the general level of prices.

In the case of the 3% price inflation, the nominal rate of interest would be set at 8%, so that when the loan is paid off, the lender still receives his gain of 5% in real purchasing power. And in the case of 3% price deflation, the nominal rate of interest would be set at 2%, so that when the loan is paid off, the lender receives his real gain of 5% in real purchasing power.

In the real world, however, Fisher said, changes in the general level of prices are unlikely to be perfectly and correctly anticipated by lenders and borrowers. As a consequence, there is always the possibility of unforeseen and unagreed-to gains and losses by creditors and debtors.

Furthermore, Fisher argued, unexpected changes in the general level of prices can have disruptive effects on production and employment in the economy as a whole. This was a theme that he developed in his 1911 work, The Purchasing Power of Money, and that he popularized in a series of books, such as his Elementary Principles of Economics (1912), Stabilizing the Dollar (1920), and The Money Illusion (1928), and in dozens of articles he published throughout the 1920s.

He said that during a period of unexpected price inflation or price deflation, prices for finished goods and services and the prices for resources and labor change at different times and to different degrees. As a result, profit margins between the prices for finished goods and the means of production can be artificially and temporarily increased or decreased, resulting in fluctuations in production and employment in the economy.

Prices for finished consumer goods, Fisher explained, tend to be fairly flexible and responsive to changes in the level of market demand. On the other hand, resource prices, including the wages for labor, tend to be fixed for periods of time by contract. (See “Monetary Central Planning and the State, Part I,” in Freedom Daily , January 1997.)

During periods of unexpected price inflation, the profit margins between consumer-goods prices and resource prices are artificially widened, creating an incentive for employers to try to expand output to take advantage of the increased return from sales. This, he argued, is the cause of the “boom,” or expansionist, phase of the business cycle.

But the boom inevitably comes to an end when resource prices, including wages, come up for contractual renegotiation. Resource owners and laborers, in a market environment of heated demand for their services, bargain for higher prices and money wages to compensate for the lost purchasing power they have suffered while their money incomes have been contractually fixed in the face of rising prices.

The “bust” or contractionist phase of the business cycle then sets in, as profit margins narrow in the face of the new higher costs of production and as employers discover that they have overexpanded and overextended themselves in the earlier boom period.

During periods of unexpected price deflation, profit margins between consumer-goods prices and resource prices are artificially narrowed or wiped out, as consumer-goods prices are declining while resource prices and wages temporarily remain fixed at their contractual levels. Employers have an incentive to reduce output to economize on costs and reduce loses, generating a general economic downturn. The diminished profits or losses are eliminated when resource prices (including wages) come up for contractual renegotiation. Rather than risk losing their businesses and jobs, resource owners and workers moderate their price and wage demands to reflect the lower prices in the marketplace for their products.

Furthermore, since consumer-goods prices, in general, are declining, resource owners and workers can accept lower resource prices and money wages. In real buying terms, they will be no worse off than before the price deflation began.

If price inflations and price deflations could be perfectly anticipated, the changes in the purchasing power of money could be incorporated into resource and labor contracts, with profit margins being neither artificially widened nor narrowed by the movements in the general level of prices. The business cycle of booms and busts would be mitigated or even eliminated.

Unfortunately, Fisher again argued, such perfect foresight is highly unlikely. And unless some external force is introduced to keep the price level stable — to eliminate both price inflations and price deflations — Fisher concluded that, given the monetary institutions prevailing in most modern societies during the time he was writing, the business cycle would remain an inherent part of a market economy.

Irving Fisher’s solution was to advocate a stabilization of the price level . What was needed, he insisted, was a monetary policy that would ensure neither price inflation nor price deflation. In Stabilizing the Dollar (1920), Fisher stated:

“What is needed is to stabilize, or standardize, the dollar just as we have already standardized the yardstick, the pound weight, the bushel basket, the pint cup, the horsepower, the volt, and indeed all the units of commerce except the dollar. . . . Am I proposing that some Government official should be authorized to mark the dollar up or down according to his own caprice? Most certainly not. A definite and simple criterion for the required adjustments is at hand — the familiar “index number” of prices. . . . For every one per cent of deviation of the index number above or below par at any adjustment date, we would increase or decrease the dollar’s weight (in terms of purchasing power) by one per cent.”

How would the government do this? By changing the quantity of money and bank credit available in the economy for the purchase of goods and services. In his 1928 volume, The Money Illusion , Fisher praised the Federal Reserve Board — the American central bank’s monetary managers — for following a policy since 1922 close to the one he was advocating. Though only a “crude” beginning, “stabilization ushers in a new era for our economic life . . . adding much to the income of the nation,” he claimed.

“The dollar . . . has been partially safeguarded against wide fluctuations ever since the Federal Reserve System finally set up the Open Market Committee in 1922 to buy and sell securities, especially Government bonds, for the purpose of influencing the credit situation. . . . When they buy securities they thereby put money into circulation. . . . When they sell, they thereby withdraw money from circulation. [Along with the Federal Reserve’s control over bank reserves and the discount rate at which it directly lends to banks, through Open Market Operations] the Federal Reserve does and should safeguard the country . . . against serious inflation and deflation. . . . This power, rightly used, makes the Federal Reserve System the greatest public service institution in the world.”

Through the power of the Federal Reserve System, Fisher happily pointed out, America had established a “managed currency,” guided by the policy goal of a stable price level.

Even on the eve of the great stock market crash that occurred during the last two weeks of October 1929, Irving Fisher declared on September 5, 1929, “There may be a recession in stock prices, but not anything in the nature of a crash.” And on October 16, 1929, Fisher insisted:

“Stock prices have reached what looks like a permanently high plateau. I do not feel that there will soon, if ever, be a fifty or sixty point break below present levels. . . . I expect to see the stock market a good deal higher than it is today within a few months.”

The great American experiment in monetary central planning for price level stabilization during the 1920s ended in disaster. Along with the government’s interventionist responses to the economic crisis, first by the Hoover administration and then with even greater force during the Roosevelt administration’s New Deal, America’s monetary central planners created the decade-long Great Depression.

What exactly had the Federal Reserve System done in the 1920s, in terms of monetary policy? Why, in fact, did this policy end up being a recipe for disaster? And why did the responses by the Hoover and Roosevelt administrations exacerbate the crisis, turning it into America’s Great Depression?

Categories: Freedom Daily Archive, Monetary Policy