The Coming Monetary Tsunami

Remember pictures of the devastation wrought upon Southeast Asia by the Tsunami a few years ago? An underwater earthquake thousands of miles away lifted up the ocean and created a giant tidal wave that smashed unsuspecting coastal villages along thousands of miles of coast many hours later. One of the perverse characteristics of a tsunami is that the coastal tide actually retreats for some time before the tidal wave arrives. People walked out to areas that were formerly ocean bottoms and marveled at what would cause such a drop in the tide. They found out.
Like the unseen tsunami far out at sea, our leaders in Washington reassure us that there is no tidal wave of higher prices that is rushing towards us, triggered by their massive expansion of bank reserves that will translate into a doubling of the money supply. It hasn’t reached our shores yet, so why worry? In fact they point to the drop in many prices to justify their confidence that there is no cause and effect that links profligate spending and money expansion with higher prices.
The Austrian School of Economics is very careful with its terms and its theories. We Austrians call any expansion of the money supply not supported by an underlying commodity (such as gold or silver) to be inflation. All other things being equal, inflation of the money will cause higher prices at some point in the future. Higher prices, therefore, are not inflation—they are just higher prices.
Although it is not quite this simple, think of money as the clearing mechanism for goods and services. It is possible to expand the money supply in an inflationary way—that is, not supported by a commodity—and still experience lower prices IF goods and services expand, too. Let us consider the following scenario. Let us assume that a few years in the past the people changed their spending/savings ratio to funnel more money to savings and less to current consumption. Let us also assume that the money supply remained stable. This increase in savings will have two beneficial effects. One, prices of current goods will fall. The money supply remained unchanged, yet more of it is saved. This smaller quantity of money going to current consumption meets an existing inventory of goods and services that came into being expecting that consumption would be higher than it is. The only way the market can clear—sell—these goods is for prices to fall. Now the smaller pool of money for consumption can clear the now-too-large pool of goods and services available for sale. The market achieves a new equilibrium, just as predicted by Jean Baptiste Say. A few years go by and the new pool of savings has been funneled into longer-term production processes. These new producer goods start pumping out consumer goods in greater quantities; the nation’s production possibility frontier has expanded just as predicted by Eugene Bohm-Bawerk. This greater flow of goods and services reaches the market at the same time that the central bank engages in an expansion of the money supply. Had the central bank not expanded the money supply, the price of goods and services would have fallen, a most welcome event. But the money supply did expand—what Austrians call inflation—so prices do not fall at all or perhaps fall only slightly. Can the central bank claim that its policies were unconnected with the price level? Of course not! This scenario explains what actually happened in the 1920s. Rapid technological development led to greater output that caused prices to remain stable even though the Fed expanded the money supply in an inflationary way (i.e., not linked to an increase in gold).
Next lets examine the opposite scenario. Again the central bank keeps the money supply stable, but something happens to cause a drop in the nation’s production of goods and services. Perhaps there was some natural disaster, like Hurricane Katrina, that temporarily destroyed part of the nation’s oil production and refining capacity. Fewer goods and service reach market. Prices rise when the market realizes that its inventories are depleting too fast to avoid shortages. Did the central bank cause prices to rise? No.
Here’s another scenario. For whatever reason, the nation’s economy moves into recession. There is an excess of goods and services available for sale, but people are not buying. Perhaps, like the present time, a previous expansion of credit has resulted in large-scale malinvestment and business losses. Businesses are failing and unemployment rises. Consumption drops. Prices fall in a normal market reaction to clear inventories. But…the central bank intervenes to expand the money supply rather than allow the economy to clear the excess inventory and wait while workers find new jobs in industries that are still profitable. This takes time. Now bank reserves have been bolstered, and the money supply has grown somewhat but not to its full extent consistent with the new level of bank reserves. This too takes time. In the interim, prices fall. Can the central bank claim that its actions have no impact on prices? Of course not. The central bank has engaged in inflationary actions by creating the bank reserves that will be turned into an expansion of the money supply when confidence returns. Confidence will return—at least for awhile—when unemployed workers find new jobs and start spending again. But the increased money supply will find an old level of production, perhaps even a decreased level of production. The market will detect the excess money and start to raise prices in order to avoid shortages. The market will reach a new equilibrium at a new higher price level. This has been the series of events since the founding of the Fed in 1913. The price level today is twenty times what it was in 1913. Contrast this lamentable experience with the fifty years PRIOR to the founding of the Fed. The price level drop an average of four percent per year for fifty years, consistent with a stable price level, tied to gold, and increased productivity by American businesses and workers. The dollar truly earned its place in the common phrase "as sound as a dollar".
The lesson of all this is that our governmental leaders have set the stage for a tremendous increase in prices sometime in the future. No one knows when this tsunami will strike. But I wouldn’t venture too far out on the now-exposed ocean floor of lower prices if I were you.