June 9, 2010

Keynesian economists speak of deflation as a calamity. They use the word, of course, to mean price deflation and, in fact, they view a drop in price levels itself to be a disaster. Why?

Keynesian economists in the Federal Reserve increase the money supply to achieve what they see as prosperity. (Actually it’s a bubble of malinvestment that eventually must collapse.) The Keynesians see resulting increasing price levels as a healthy symptom of prosperity. So when prices fall, they fear that the bubble may burst.

If the Federal Reserve does nothing at this point, and allows the market to redirect the economy to a more profitable balance, banks will call in loans they now consider risky and increase interest rates. The failing new enterprises of the bubble will quickly shut down, sending redundant workers and materials back into more profitable enterprises. This happened in 1921 and the resulting recession ended quickly in 1922

If the Federal Reserve sees the looming troubles in time and acts as all good Keynesians do, they will force down interest rates to re-inflate the money supply. This may sustain the bubble for a while. When, inevitably, the bubble breaks, the losses will be far greater than they would have been if they had let the banks and entrepreneurs pursue sensible policy, to minimize their losses. When the Federal Reserve reacted with reduced interest rates and increasing money supply in the 1930s, we had the notorious great depression that lasted from 1932 to 1947

Manipulating the money supply always causes transfers of wealth. With inflation, bubbles cause the transfer of materials and labor from ongoing profitable production to capital goods (buildings and tools) for speculative new projects. The last segment of the economy to get adjusted to increased price levels is labor- wages never catch up with increasing prices. Remember, Keynes sold inflation to governments as a stealthy way to reduce real wages.
With deflation, materials and labor will slowly return to more mundane but profitable production. Prices will fall, and workers, at last, will get some benefit, because wages will be the last to fall. Labor will get some temporary benefit from the falling prices until their wages fall, too.

The trouble with the dollar is that it can be manipulated. It is a government creation. Government can create or destroy it at will. Fractional reserve banking makes an ideal tool for the manipulation of the money supply, by creating and destroying credit, which becomes dollars in circulation as soon as the borrower spends it, and disappears when the loan is paid off. This is play money, a fiat currency which the government uses to control the economy and to tax us invisibly.

The advantage of the gold standard is that it defines the dollar in terms of gold. Gold cannot be created or counterfeited.

The disadvantage of the gold standard is that the government defines the standard, and can change the definition at will. In the course of 40 years (1931 to 1971), our government redefined the dollar from 1/20th Troy ounce of gold to 1/35th ounce and then to 1/70th ounce of gold, and finally, to no gold at all. The dollar was legally worthless.

Far superior to the dollar or the gold standard is the use of gold itself as money. That, the government cannot manipulate. Someday, we will take back from our government the freedom to use gold, silver, or anything else we choose, as money.

If we can use gold as money, and establish banking without fractional reserves, we can say goodbye to the business cycle, bubbles, booms, busts, and depressions, inflation, deflation, and the stealth tax. This will never be a free country until we have that freedom.


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