Something very similar happened in Russia during the First World War and in the years immediately after the revolutions of 1917. By 1921, the amount of currency issued by the Russian government was hundreds of times greater than the currency in circulation on the eve of the war in 1913—and the price level rose to thousands of times higher than in 1913.{579} When the money circulates faster, the effect on prices is the same as if there were more money in circulation. When both things happen on a large scale simultaneously, the result is runaway inflation. During the last, crisis-ridden year of the Soviet Union in 1991, the value of the ruble fell so low that Russians used it for wallpaper and toilet paper, both of which were in short supply.{580}
Perhaps the most famous inflation of the twentieth century occurred in Germany during the 1920s, when 40 marks were worth one dollar in July 1920, but it took more than 4 trillion marks to be worth one dollar by November 1923. People discovered that their life’s savings were not enough to buy a pack of cigarettes. The German government had, in effect, stolen virtually everything they owned by the simple process of keeping more than 1,700 printing presses running day and night, printing money.{581} Some have blamed the economic chaos and bitter disillusionment of this era for setting the stage for the rise of Adolf Hitler and the Nazis. During this runaway inflation, Hitler coined the telling phrase, “starving billionaires,”{582} for there were Germans with a billion marks that would not buy enough food to feed themselves.
The rate of inflation is often measured by changes in the consumer price index. Like other indexes, the consumer price index is only an approximation because the prices of different things change differently. For example, when consumer prices in the United States rose over the previous 12 months by 3.4 percent in March 2006, these changes ranged from a rise of 17.3 percent for energy to 4.1 percent for medical care and an actual decline of 1.2 percent in the prices of apparel.{583}
While the effects of deflation are more obvious than the effects of inflation—since less money means fewer purchases, and therefore lower production of new goods, with correspondingly less demand for labor—the effects of inflation can likewise bring an economy to a halt. Runaway inflation means that producers find it risky to produce, when the price at which they can sell their output may not represent as much purchasing power as the money they spent producing that output. When inflation in Latin America peaked at about 600 percent per year in 1990, real output in Latin America fell absolutely that same year. But, after several subsequent years of no inflation, real output hit a robust growth rate of 6 percent per year.{584}
Deflation
While inflation has been a problem that is centuries old, at particular times and places deflation has also created problems, some of them devastating.
From 1873 through 1896, price levels declined by 22 percent in Britain, and 32 percent in the United States.{585} These and other industrial nations were on the gold standard and output was growing faster than the world’s gold supply. While the prices of current output and inputs 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. This problem for debtors became a problem for creditors as well, when the debtors could no longer pay and simply defaulted.
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.
An even more disastrous deflation occurred in twentieth-century America. As noted at the beginning of Chapter 16, the money supply in the United States declined by one-third from 1929 to 1933, making it impossible for Americans to buy as many goods and services as before at the old prices. Prices did come down—the Sears catalog for 1931 had many prices that were lower than they had been a decade earlier—but some prices could not change because there were legal contracts involved.
Mortgages on homes, farms, stores, and office buildings all specified monthly mortgage payments in specific money amounts. These terms might have been quite reasonable and easy to meet when the total amount of money in the economy was substantially larger, but now it was the same as if these payments had been arbitrarily raised—as in fact they were raised in real purchasing power terms. Many homeowners, farmers and businesses simply could not pay after the national money supply contracted—and therefore they lost the places that housed them. People with leases faced very similar problems, as it became increasingly difficult to come up with the money to pay the rent. The vast amounts of goods and services purchased on credit by businesses and individuals alike produced debts that were now harder to pay off than when the credit was extended in an economy with a larger money supply.
Those whose wages and salaries were specified in contracts—ranging from unionized workers to professional baseball players—were now legally entitled to more real purchasing power than when these contracts were originally signed. So were government employees, whose salary scales were fixed by law. But, while deflation benefitted members of these particular groups if they kept their jobs, the difficulty of paying them meant that many would lose their jobs.
Similarly, banks that owned the mortgages which many people were struggling to pay were benefitted by receiving mortgage payments worth more purchasing power than before—if they received the payments at all. But so many people were unable to pay their debts that many banks began to fail. More than 9,000 banks suspended operations over a four year period from 1930 through 1933.{586} Other creditors likewise lost money when debtors simply could not pay them.
Just as inflation tends to be made worse by the fact that people spend a depreciating currency faster than usual, in order to buy something with it before it loses still more value, so a deflation tends to be made worse by the fact that people hold on to money longer, especially during a depression, with widespread unemployment making everyone’s job or business insecure. Not only was there less money in circulation during the downturn in the economy from 1929 to 1932, what money there was circulated more slowly,{587} which further reduced demand for goods and services. That in turn reduced demand for the labor to produce them, creating mass unemployment.
Theoretically, the government could have increased the money supply to bring the price level back up to where it had been before. The Federal Reserve System had been set up, nearly 20 years earlier during the Woodrow Wilson administration, to deal with changes in the nation’s money supply. President Wilson explained that the Federal Reserve “provides a currency which expands as it is needed and contracts when it is not needed” and that “the power to direct this system of credits is put into the hands of a public board of disinterested officers of the Government itself”{588} to avoid control by bankers or other special interests.
However reasonable that sounds, what a government can do theoretically is not necessarily the same as what it is likely to do politically, or what its leaders understand intellectually. Moreover, the fact that government officials have no personal financial interest in the decisions they make does not mean that they are “disinterested” as regards the political interests involved in their decisions.
Even if Federal Reserve officials were unaffected by either financial or political interests, that does not mean that their decisions are necessarily competent—and, unlike people whose decisions are subject to correction by the market, government decision-makers face no such automatic correction. Looking back on the Great Depression of the 1930s, both conservative and liberal economists have seen the Federal Reserve System’s monetary policies during that period as confused and counterproductive. Milton Friedman called the people who ran the Federal Reserve System in those years “inept”{589} and John Kenneth Galbraith called them a group with “startling incompetence.”{590} For example, the Federal Reserve raised the interest rate in 1931,{591} as the downturn in the economy was nearing
the bottom, with businesses failing and banks collapsing by the thousands all across the country, along with massive unemployment.
Today, anyone with just a basic knowledge of economics would be expected to understand that you do not get out of a depression by raising the interest rate, since higher interest rates reduce the amount of credit, and therefore further reduce aggregate demand at a time when more demand is required to restore the economy.
Nor were the presidents who were in office during the Great Depression any more economically sophisticated than the Federal Reserve officials. Both Republican President Herbert Hoover and his Democratic successor, Franklin D. Roosevelt, thought that wage rates should not be reduced, so this way of adjusting to deflation was discouraged by the federal government—for both humanitarian and political reasons. The theory was that maintaining wage rates in money terms meant maintaining purchasing power, so as to prevent further declines in sales, output and employment.
Unfortunately, this policy works only so long as people keep their jobs—and higher wage rates under given conditions, especially deflation, mean lower employment. Therefore higher real wage rates per hour did not translate into higher aggregate earnings for labor, and so provided no basis for the higher aggregate demand that both presidents expected. Joseph A. Schumpeter, a leading economist of that era, saw resistance to downward adjustments in money wages as making the Great Depression worse. Writing in 1931, he said:
The depression has not been brought about by the rate of wages, but having been brought about by other factors, is much intensified by this factor.{592}
It was apparently not necessary to be an economist, however, to understand what both Presidents Hoover and Roosevelt did not understand. Columnist Walter Lippmann, writing in 1934, said, “in a depression men cannot sell their goods or their service at pre-depression prices. If they insist on pre-depression prices for goods, they do not sell them. If they insist on pre-depression wages, they become unemployed.”{593} The millions of unemployed—many in desperate economic circumstances—were not the ones demanding pre-depression wages. It was politicians who were trying to keep wages at pre-depression levels.
Both the Hoover administration and the subsequent Roosevelt administration applied the same reasoning—or lack of reasoning—to agriculture that they had applied to labor: The prices of farm products were to be kept up by the government, in order to maintain the purchasing power of farmers. President Hoover decided that the federal government should “give indirect support to prices which had seriously declined” in agriculture.{594} President Roosevelt later institutionalized this policy in agricultural price support programs which led to mass destructions of food at a time of widespread hunger. In short, misconceptions of economics were both common and bipartisan.
Nor were misconceptions of economics confined to the United States. Writing in 1931, John Maynard Keynes said of the British government’s monetary policies that the arguments being made for those policies “could not survive ten minutes’ rational discussion.”{595}
Monetary policy is just one of many areas in which it is not enough that the government could do things to make a situation better. What matters is what government is in fact likely to do, which can in many cases make the situation worse.
It is not only during national and international catastrophes, such as the Great Depression of the 1930s, that deflation can become a serious problem. During the heyday of the gold standard in the nineteenth and early twentieth centuries, whenever the production of goods and services grew faster than the gold supply, prices tended to decline, just as prices tend to rise when the money supply grows faster than the supply of the things that money buys.
The average price level in the United States, for example, was lower at the end of the nineteenth century than at the beginning. As in other cases of deflation—that is, an increase in the purchasing power of money—this made mortgages, leases, contracts, and other legal obligations payable in money grow in real value. In short, debtors in effect owed more—in real purchasing power—than they had agreed to pay when they borrowed money.
In addition to problems created by legal obligations fixed in money terms, there are other problems created by deflation that result from different people’s incomes being affected differently by price changes. Deflation—like inflation—affects different prices differently. In the United States, as already noted, the prices of what farmers sold tended to fall faster than the prices of what they bought:
The price of wheat, which had hovered around a dollar a bushel for decades, closed out 1892 under ninety cents, 1893 around seventy-five cents, 1894 barely sixty cents. In the dead of the winter of 1895–1896, the price went below fifty cents a bushel.{596}
Meanwhile, farmers’ mortgage payments remained where they had always been in money terms—and therefore were growing in real terms during deflation. Moreover, payments on these mortgages now had to be paid out of farm incomes that were half or less of what they had been when these mortgages were taken out. This was the background for William Jennings Bryan’s campaign for the presidency in 1896, based on a demand to end the gold standard, and was climaxed by his dramatic speech saying “you shall not crucify mankind upon a cross of gold.”{597}
At a time when more people lived in the country than in the cities and towns, he was narrowly defeated by William McKinley. What really eased the political pressures to end the gold standard was the discovery of new gold deposits in South Africa, Australia, and Alaska. These discoveries led to rising prices for the first time in twenty years, including the prices of farm produce, which rose especially rapidly.
With the deflationary effects of the gold standard now past, not only was the political polarization over the issue eased in the United States, more countries around the world went onto the gold standard at the end of the nineteenth century and the beginning of the twentieth century. However, the gold standard does not prevent either inflation or deflation, though it restricts the ability of politicians to manipulate the money supply, and thereby keeps both inflation and deflation within narrower limits. Just as the growth of output faster than the growth of the gold supply has caused a general fall in the average price level, so discoveries of large gold deposits—as in nineteenth century California, South Africa, and the Yukon—caused prices to rise to inflationary levels.{598}
THE BANKING SYSTEM
Why are there banks in the first place?
One reason is that there are economies of scale in guarding money. If restaurants or hardware stores kept all the money they received from their customers in a back room somewhere, criminals would hold up far more restaurants, hardware stores, and other businesses and homes than they do. By transferring their money to a bank, individuals and enterprises are able to have their money guarded by others at lower costs than guarding it themselves.
Banks can invest in vaults and guards, or pay to have armored cars come around regularly to pick up money from businesses and take it to some other heavily guarded place for storage. In the United States, Federal Reserve Banks store money from private banks and money and gold owned by the U.S. government. The security systems there are so effective that, although private banks get robbed from time to time, no Federal Reserve Bank has ever been robbed. Nearly half of all the gold owned by the German government was at one time stored in the Federal Reserve Bank of New York.{599} In short, economies of scale enable banks to guard wealth at lower costs per unit of wealth than either private businesses or homes, and enable the Federal Reserve Banks to guard wealth at lower costs per unit of wealth than private banks.
THE ROLE OF BANKS
Banks are not just storage places for money. They play a more active role than that in the economy. As noted in earlier chapters, businesses’ incomes are unpredictable and can go from profits to losses and back again repeatedly. Meanwhile, businesses’ legal obligations—to pay their employees every payday and pay their electricity bills regularly, as well as paying those who supply them with all
the other things needed to keep the business running—must be paid steadily, whether or not the bottom line has red ink or black ink at the moment. This means that someone must supply businesses with money when they don’t have enough of their own to meet their obligations at the time when payment is due. Banks are a major source of this money, which must of course be repaid from later profits.
Businesses typically do not apply for a separate loan each time their current incomes will not cover their current obligations. It saves time and money for both the businesses and the banks if the bank grants them a line of credit for a given sum of money and the business uses up to that amount as circumstances require, repaying it when profits come in, thus replenishing the fund behind the line of credit.
Theoretically, each individual business could save its own money from the good times to tide it over the bad times, as businesses do to some extent. But here, again, there are economies of scale in having commercial banks maintain a large central fund from which individual businesses can draw money as needed to maintain a steady cash flow to pay their employees and others. Commercial banks of course charge interest for this service but, because economies of scale and risk-pooling make the commercial banks’ costs lower than that of their customers, both the banks and their customers are better off financially because of this shifting of risks to where the costs of those risks are lower.
Banks not only have their own economies of scale, they are one of a number of financial institutions which enable individual businesses to achieve economies of scale—and thereby raise the general public’s standard of living through lower production costs that translate into lower prices. In a complex modern economy, businesses achieve lower production costs by operating on a huge scale requiring far more labor, machinery, electricity and other resources than even rich individuals are able to afford. Most giant corporations are not owned by a few rich people but draw on money from vast numbers of people whose individually modest sums of money are aggregated and then transferred in vast amounts to the business by financial intermediaries like banks, insurance companies, mutual funds and pension funds.
Basic Economics Page 43