Inflation Comes in Phases

One of the most interesting things that I recently learned is that "inflation" is a process; it comes in phases. 

According to Murray N. Rothbard's book The Mystery of Banking, inflation comes in phases.  This conclusion was derived earlier by Ludwig von Mises in his study of the German hyperinflation of 1923.

If you were to take a sophomore-level macro-economics course, you would be told that money is neutral, i.e., if the money supply were to double then the price level would also double.  What is interesting about this "inflation phases" theory is that the money neutrality assumption presented in the textbooks does not hold.  In fact, in Phase I, the money supply expands much more than the price level rises.  This is because there are two conflicting forces at work:  the money supply and the behavior of expectations.  The expanding money supply will, for a given demand for money curve, cause the price level to rise, which is the same thing as saying that the purchasing power of money will fall.  However, according to the Misesian inspired theory presented by Rothbard, a second force operates against the first, namely, a change in expectations partially offsets the effects of the money supply expansion.  In particular, the model assumes that in Phase I deflationary expectations exist, i.e., people expect to see a lower price level in the near future.  This implies that people are willing to hold much larger cash balances; consequently, their demand for money increases.  A higher demand for money for any given supply of money tends to depress prices or to increase the purchasing power of money.  The reason why deflationary expectations cause people to want to hold more money is simply that people are anticipating a "bargain" in the future.  People are expecting much lower prices in the future; consequently, they want to stock up on money so that they can go on a shopping spree in the future.  Consequently, we might see a 50% increase in the money supply but only a 10% increase in prices. 

The other observation that I want to make at this point is this:  I was surprised that the Mises-Rothbard theory incorporated expectations, specifically deflationary expectations.  When I flipped through Roger Garrison's book Time and Money:  The Macroeconomics of Capital Structure, I got the impression that "expectations" were problematic for Austrian school macroeconomics.  "What about expectations" was the refrain of the critics back during the big 1930s debates, which inspired Garrison's book (the whole Keynes versus Hayek theme).  For example, Garrison writes, "But in countering Keynes's "expectations without capital theory," Hayek (our Austrian economist in the Mises-Rothbard school) produced--or so it could be argued--a "capital theory WITHOUT EXPECTATIONS."  Granted that their might be a subtle way to reconcile these two works.  And of course, I might be in error because Garrison's book is on capital structure while Rothbard's is on money and banking, so I might be trying to link two dissimilar discussions.  I am not sure; I am still learning all these theories.  I just wanted to point out a possible point of inconsistency or discrepancy.  Still, it seemed to me from Garrison's book that "expectations" was a weak spot (at least when the discussion was about Hayek's triangles and capital theory), so seeing expectations playing such a major role in the Mises-Rothbard theory was a bit shocking for me.  I am intrigued; I wonder what to make of it all.  Maybe "expectations" are not so problematic to the Austrian macroeconomic model after all since Rothbard incorporates expectations in his model by allowing for changes in expectations that then cause changes in the demand for money curve, i.e., the curve will shift either to the right or to the left because of changes in expectations. 

In conclusion, the biggest shocker for me was to learn that "inflation comes in phases."  I never knew that before.  Second, the idea that the money supply and the price level can change but in disproportionate amounts (e.g., money supply goes up 100% but prices go up only 15%) was also new to me.  Finally, I was also a bit surprised that the Mises-Rothbard model did incorporate expectations.  These are the three surprises that I have come across so far in Rothbard's "Mystery of Banking."  Since I am still reading this book, I expect to find many more interesting discoveries, which I will share.

Inflation, the United States Supreme Court, and Corporate Welfare

The panic of 1873 was a severe blow to many overbuilt railroads, and it was railroad men who LED in calling for MORE GREENBACKS to stem the tide.  Thomas Scott; Collis P. Huntington, leader of the Central Pacific Railroad; Russel Sage; and other railroad men joined in the call for greenbacks.  So strong was their influence that the Louisville Courier-Journal, in April 1874, declared:  "The strongest influence at work in Washington upon the currency proceeded from the railroads....THE GREAT INFLATIONISTS AFTER ALL, ARE THE GREAT TRUNK RAILROADS."  --Murray N. Rothbard, A History of Money and Banking in the United States:  The Colonial Era to World War II, 150, emphasis mine)

 Rothbard's introductory quote stresses the fact that some of the largest corporations are in fact the biggest sponsors of a policy of inflation.  The reason why is that most of these railroads were heavily in debt; consequently, the railroad men saw an inflationary policy as a means to their desired end, that end being a reduction in their long-term debt burden.  As Ludwig von Mises notes in his article entitled Socialism, Inflation, and the Thrifty Householder, "the more inflation progresses, the more is the debtor favored at the expense of the creditor" (Article 21 of Economic Freedom and Interventionism, 120).  Mises came to the same conclusion that the Louisville Courier-Journal did back in 1874, namely, that the large corporations are usually heavily in debt so that they are the biggest beneficiaries of inflation.  Mises stresses the point that the common man is by far a creditor and therefore the common man is the biggest loser from inflationary policies.  Mises made the following important observations of this general tendency of inflation to benefit the heavily in debt corporations at the expense of the common man by noting that

in the balance the common man is by far a creditor, not a debtor.  The billions of dollars that big business and real estate owe to mortgage banks, commercial banks, savings banks, and insurance companies belong--virtually, although not formally--to the common man....A policy of "creeping inflation" such as this country has now pursued for a long series of years--apart from all the other detrimental effects it produces--is in the strict meaning of the words antisocial and antidemocratic.  It is a policy against the vital material interests of the common man.  (Ludwig von Mises, Socialism, Inflation, and the Thrifty Householder, Article 21 of Economic Freedom and Interventionism, 121-122, emphasis mine)

The railroads, to be sure, were not only using inflation as a form of corporate welfare; they had a whole laundry list of additional techniques at their disposal.  According to Thomas J. DiLorenzo's book How Capitalism Saved America:  The Untold History of Our Country, from the Pilgrims to the Present, in Chapter 7 "The Truth About the 'Robber Barons,'" an important distinction is made between those who acquire wealth through political means and those who acquire wealth through economic means.  DiLorenzo's distinction is reminiscent of the distinction made by Franz Oppenheimer in the latter's work on the Origins of the State itself.  Most of the railroads used the "political means" and became entangled in numerous government backed schemes with the notable exception being James J. Hill's railroad.  DiLorenzo paints the stark contrast between these two groups by noting that "Jay Cooke was not the only one whose government-subsidized railroad ended up in bankruptcy.  In fact, Hill's Great Northern was the ONLY transcontinental railroad that never went bankrupt" (115-116, emphasis mine).  Hill, of course, used the "economic means" to acquiring wealth because Hill built his Great Northern Railroad "without any government aid, even the right of way, through hundreds of miles of public lands, being paid for in cash," (112, emphasis mine).  Therefore, the inflationary tool for getting out of debt, which both Mises and Rothbard mention, is only one special type of this much bigger and broader "corporate welfare" problem.

Nevertheless, the inflationary tool is certainly a potent weapon in the arsenal of large corporations trying to avoid paying their long-term debts.  The government is a willing accomplice to this crime in many ways.  One obvious way would be to stress the government created central banking system, which certainly plays a major role in our modern discussions of this government-business corporate welfare problem.  However, back in the 1870s, the United States banking system was not a central banking system.  Granted, there were successful steps being taken in this direction going back to at least the early 1860s.  As Thomas DiLorenzo notes in his book Hamilton's Curse:  How Jefferson's Archenemy Betrayed the American Revolution--and What It Means for Americans Today, the neo-Hamiltonian Republicans, that is Republicans influenced by the works of Alexander Hamilton and Henry Clay, the administration of Abraham Lincoln launched many pro-inflationist banking reforms.  DiLorenzo observed that the monopolization process of the American banking industry began in February 1862:

These [Legal Tender] acts of legislation permitted the treasury secretary to issue paper currency (greenbacks) that was not immediately redeemable in gold or silver.  Then they passed the National Currency Acts of 1863 and 1864, which created a system of nationally chartered (and regulated) banks that could issue currency.  A punitive 10 percent tax was placed on state-chartered banks in order to drive them into bankruptcy.  The neo-Hamiltonians were candid about their intention to create an "unqualified government monopoly."  (127)

All of these areas are very important since they are all contributing factors in explaining the corporate welfare schemes used to bail out big businesses and railroads in particular.  In fact the railroad corporate welfare schemes started in 1862 when "Congress, with the southern Democrats gone, diverted millions of dollars from the [Civil] war effort to begin building a subsidized railroad" (Thomas J. DiLorenzo, How Capitalism Saved America, 116, emphasis mine).  I do not want to downplay the importance of these other contributing factors; nevertheless, another important contributing factor THAT IS OFTEN OVERLOOKED is the ROLE PLAYED BY THE UNITED STATES SUPREME COURT IN BACKING THESE CORPORATE WELFARE SCHEMES.


Returning to the introductory quote from Rothbard, the economic means for reducing the debt load of the railroads was certainly a pro-inflationary scheme supported by the banking system.  However, there was a problem for the railroads, namely, the United States Constitution, which was initially interpreted by the Supreme Court of the United States in such a way that harmed the railroads because the Court initially was anti-inflationary in its rulings.  However, because of political interference in Supreme Court appointments, the Grant administration was able to get the earlier decisions changed.  Therefore, the United States Supreme Court also contributed to the pro-inflationary and hence pro-corporate welfare schemes of the railroad corporations.  Rothbard documents all the details in his A History of Money and Banking in the United States:  The Colonial Era to World War II and shows clearly how the "political means" mentioned earlier by both DiLorenzo and by Oppenheimer were at play in helping the railroad industry avoid paying its debts to its creditors:

The Grant administration was upset by Hepburn v. Griswold, as were the railroads, who had accumulated a heavy long-term debt, which would now be payable in more valuable gold.  As luck would have it, however, there were two vacancies on the Court, one of which was created by the retirement of one of the majority judges.  Grant appointed not only two Republican judges, but two railroad lawyers whose views on the subject were already known.  The new 5-4 majority dutifully and quickly reconsidered the question, and, in May 1871, reversed the previous Court in the fateful decision of Knox v. Lee.  From then on, paper money would be held consonant with [i.e., in agreement with] the U.S. Constitution. (153)

 In conclusion, we see that the economic tool of inflation can be used to bail out railroads and other large corporations who took on too much debt.  However, to actually implement such a fraudulent scheme, the political apparatus must also be utilized.  Notice how Congress, the President, and the Supreme Court all played roles in aiding and abetting the various corporate welfare schemes for the railroad industry.  The behavior of the Grant administration, which amounted to rigging the Supreme Court with political partisans, raises a serious question about the impartiality and justice of the entire governmental system in the United States.  Maybe a future article could address the following research question that flows naturally from this discussion:  "Is corporate welfare inherently unjust, a violation of the rule of law?"

Why Do the Wealthy Favor Inflation, Part 1

One intriguing aspect of both the Massachusetts Land Bank and other inflationary colonial schemes is that they were advocated and lobbied for by some of the wealthiest merchants and land speculators in the respective colonies.  Debtors benefit from inflation and creditors lose; realizing this fact, older historians assumed that debtors were largely poor agrarians and creditors were wealthy merchants and that therefore the former were the main sponsors of inflationary nostrums.  But, of course, there are no rigid "classes" of debtors and creditors; indeed, wealthy merchants and land speculators are often the heaviest debtors.  Later historians have demonstrated that members of the latter group were the major sponsors of inflationary paper money in the colonies.  --Ron Paul and Lewis Lehrman, The Case for Gold:  A Minority Report of the U. S. Gold Commission, 25

In the introductory quotation, Ron Paul and Lewis Lehrman address a common misconception over who benefits from a deliberate policy of monetary inflation.  At the root of this misunderstanding is the faulty assumption that debtors must be the poor starving masses and that the creditors must be a handful of rich businessmen and women.  The provenance of this misinterpretation can be traced back to ancient Athens.  During an interview with Professor Percy L. Greaves, Jr., Professor Dr. Ludwig von Mises mentions that the faulty assumption can be traced back to the ideas of Solon.  Mises tells Greaves, with regard to the faulty assumption above, that

this [i.e., the faulty assumption] was perfectly correct twenty-five hundred years ago in Athens, when the great statesman Solon exacted economic reforms cancelling public and private debts.  Solon had to deal with what we today call "social problems."  At that time the debtor was typically the poor man and the creditor was the rich man.  The rich people could save and increase their possessions by investing in real property, houses, businesses, forests, and other landed property.  For the masses of the people things were different.  Most of them couldn't save at all...

But we no longer live in Athens in the days of Solon.  Nor do we live under the conditions of the Middle Ages or of the sixteenth, seventeenth, and eighteenth centuries, when the poor people couldn't save.  Under capitalistic conditions the situation is very different.  (Ludwig von Mises, On Current Monetary Problems, Article #43 in Economic Freedom and Interventionism, 214, emphasis mine).

The same misconception over who is the creditor and who is the debtor and therefore the question of who benefits from inflation and who loses was picked up by Nazi propaganda.  In fact, this entire issue is at the core of one of the major Nazi party demands, namely the elimination of "interest slavery."  In a paper entitled On Some Atavistic Economic Ideas (Article #28 in Economic Freedom and Interventionism), Mises notices that "the most spectacular manifestation of the misinterpretation of the economic meaning of the present-day creditor-debtor nexus was provided by the program of the National-Socialist-German-Labor-Party, the Nazis" (153).  The Nazi propaganda, written by Gottfried Feder, called for the "destruction of interest slavery" in the unalterable party program.  However, just as the colonial Americans in Massachusetts were confused so too the Nazis were confused.  In fact, one of the voices of dissent against Hitler and the Nazi regime published an article entitled, "Do you, average reader, know that you are a creditor?"  To this observation, Mises notes, "the German voters who practically unanimously voted for Hitler certainly did not know it" (153).

At the core of the misconception, then, is to assume incorrectly that the masses of people are not savers.  The faulty assumption is to assume that the rich are the creditors and the poor are debtors.  As Mises stressed in the article On Some Atavistic Economic Ideas, "under the modern credit organization the more opulent strata are more often debtors than creditors" and "the common man is a creditor insofar as he has taken out insurance policies, has savings deposits with commercial banks and savings banks, owns bonds whether government issued or corporate, and is entitled to receive retirement and old age pensions" (153).

I should further emphasis that the properties of the "common man" who is also a "creditor" just happen to be the "perfect storm" scenario for being victimized by an inflationary policy.  At this point, the observation that the rich are trying to use inflation as a "bail out tool" so that they can reduce the burden of their debt should be obvious.  Inflation is just a way for the rich to avoid paying their debts to the savers, the "common man" on the street.  What makes this a "perfect storm" for hurting the common man, the saver, the creditor, is that the process of new money creation (i.e., the inflationary process) is rigged to transfer wealth from one group to another group.  The most vulnerable people in this process are the ones who are on fixed incomes.  As we shall see in a moment, these fixed income victims are perfectly described by Mises in the quotation above.

Murray N. Rothbard goes to the heart of this wealth-transfer problem of inflation, which is specifically designed to hurt the creditors and savers (i.e., the "common man") when he observes that

those who get the [newly created] money early in this ripple process benefit at the expense of those who get it late or not at all.  The first producers or holders of the new money will find their stock [of money] increasing before very many of their buying prices have risen.  But, as we go down the list, and more and more prices rise, the people who get the money at the end of the process find that they lose from the inflation.  Their buying prices have all risen before their own incomes have had a chance to benefit from the new money [so their "real" cash balances will fall; they have the same amount of money in dollars but with higher prices on most goods at the store, they can now buy fewer goods and services].  And some people will NEVER get the new money at all:  either because the ripple stopped, or because they have FIXED INCOMES--from salaries or bond yields, or as pensioners or holders of annuities.  (Murray N. Rothbard, the Mystery of Banking, 50, emphasis and square bracket clarifications are both mine)

In other words, the biggest victims of inflation are the savers, the people on fixed incomes and fixed salaries.  The biggest winners from an inflationary policy are then the people with large debts and the people who are the early receivers of the newly created money.  As we saw above, the largest debtors tend to be the wealthy; consequently, the indebted wealthy people are the first beneficiaries of an inflationary policy.  The inflation effectively "bails them out" from all of their debts.  The second major group to benefit from a deliberate policy of inflation is the early receiver group.  Who are the earlier receivers of the new money?  It turns out that they are usually a group of well connected big businesses too!  In Ludwig von Mises's 1919 book entitled Nation, State, and Economy:  Contributions to the Politics and History of Our Time, citing Auspitz and Lieben, Mises notes that "during the issue of notes, the additional means of circulation will be concentrated in the hands of a small fraction of the population, e.g., of the suppliers and producers of war materials" (130, emphasis mine).  Consequently, we see that the second major group to benefit from an inflationary policy is what today we might call the "military-industrial complex."  Therefore, the two groups who benefit from inflation are the military contractors and the heavily indebted corporations and wealthy individuals.  They benefit because they not only receive the new money at the earlier stages of the rippling effect but also engineer a reduction in the real costs of their debt.  In both cases, the "common man" or the saver is hurt.  The common man experiences not only a reduction in the real value of his savings (since he is a creditor) but also a penalty for being a later receiver of the new money (or in the extreme case because he never receives any of the new money; and so his real cash balances are severely depleted).