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Advancing Austrian Economics, Liberty, and Peace

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Making Economic Sense
by Murray Rothbard
(Contents by Publication Date)

Chapter 81
Inflation Redux

Inflation is back. Or rather, since inflation never really left, inflation is back, with a vengeance. After being driven down by the severe recession of 1981-82 from over 13 % in 1980 to 3% in 1983, and even falling to 1% in 1986, consumer prices in the last few years have begun to accelerate upwards. Back up to 4-5 % in the last two years, price inflation finally drove its way into public consciousness in January 1989, rising at an annual rate of 7.2%.

Austrians and other hard-money economists have been chided for the last several years: the money supply increased by about 13% in 1985 and 1986; why didn't inflation follow suit? The reason is that, unlike Chicago School monetarists, Austrians are not mechanists. Austrians do not believe in fixed leads and lags. After the money supply is increased, prices do not rise automat- ically; the resulting inflation depends on human choices and the public's decisions to hold or not to hold money. Such decisions depend on the insight and the expectations of individuals, and there is no way by which such perceptions and choices can be charted by economists in advance.

As people began to spend their money, and the special factors such as the collapse of OPEC and the more expensive dollar began to disappear or work through their effects in the economy, inflation has begun to accelerate in response. 

The resumption and escalation of inflation in the last few years has inexorably drawn interest rates ever higher in response. The Federal Reserve, ever timorous and fearful about clamping down too tightly on money and precipitating a recession, allowed interest rates to rise only very gradually in reaction to inflation. In addition, Alan Greenspan has been talking a tough line on inflation so as to hold down inflationary expectations and thereby keep down interest yields on long-term bonds. But by insisting on gradualism, the Fed has only managed to prolong the agony for the market, and to make sure that interest rates, along with consumer prices, can only increase in the foreseeable future. Most of the nation's economists and financial experts are, as usual, caught short by the escalating inflation, and can make little sense out of the proceedings. One of the few perceptive responses was that of Donald Ratajczak of Georgia State University. Ratajczak scoffed: "The Fed always follows gradualism, and it never works. And you have to ask after a while, Don't they read their own history?"

Whatever the Fed does, it unerringly makes matters worse. First it pumps in a great deal of new money because, in the depth of recession, prices go up very little in response. Emboldened by this "economic miracle," it pumps more and more new money into the system. Then, when prices finally start accelerating, it tries to prolong the inevitable and thereby only succeeds in delaying market adjustments.

Apart from a few exceptions, moreover, the nation's economists prove to be duds in anticipating the new inflation. In fact, it was only recently that many economists began to opine that the economy had undergone some sort of mysterious "structural change," and that, as a result, inflation was no longer possible. No sooner do such views begin to take hold, than the economy moves to belie the grandiose new doctrine.

Ironically, despite the gyrations and interventions of the Fed and other government authorities, recession is inevitable once an inflationary boom has been set into motion, and will occur after the inflationary boom stops or slows down. As investment economist Giulio Martino states: "We've never had a soft landing, where the Fed brought inflation down without a recession." 

We can see matters particularly clearly if we rely on M-A (for Austrian), rather than on the various Ms issued by the Fed which are statistical artifacts devoid of real meaning. After increasing rapidly for several years, the money supply remained flat from April to August 1987, long enough to help precipitate the great stock market crash of October. Then, M-A rose by about 2.5% per year, increasing from $1,905 billion in August 1987 to $1,948 billion in July 1988. Since July, however, this modest increase has been reversed, and the money supply remained level until the end of the year, then fell sharply to $1,897 billion by the end of January 1989. From the middle of 1988, then, until the end of January 1989, the total money supply, M-A, fell in absolute terms by no less than an annual rate of 5.2%. The last time M-A fell that sharply was in 1979-80, precipitating the last great recession.

This is not an argument for the Fed to expand money again in panic. Quite the contrary. Once an inflationary boom is launched, a recession is not only inevitable but is also the only way of correcting the distortions of the boom and returning the economy to health. The quicker a recession comes the better, and the more it is allowed to perform its corrective work, the sooner full recovery will arrive. 

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