The Federal Reserve, Price Stability, and CPI

The Federal Reserve, Price Stability, and CPI
by Alex Merced

While here at LibertyisNow.com I've been discussing several economic and philosohical concepts regarding individualism and Liberty, no war is won over night yet strewn across many hard fought battles. The battle at hand is similar to the battle fought by Andrew Jackson/Martin Van Buren against the entrenched banking and government interests protected by a central bank. Aiding in the battle against these interests was treasury secretary under both presidents Levi Woodsbury who I'm now currently researching to write a book on his role in this time period and in the panic of 1837. Any primary sources you can direct me too on these subjects please send over.

So to understand the battle ahead let's go back understand why the fed was created, what was the feds purpose, and their performance.

Why the fed was created?

In the early 20th century the country was subject to very regular banking panics, a large part due to branching restrictions on banks known as Unit Banking. Although you can take a look a look at the Canadian banking system at the time which didn't have these restrictions (and no central bank) did not have the same problem with banking panics as we did. In this interview on EconTalk, economist Charles Calomaris discusses this part of history in building the context for the recent financial crisis.

Part of what really made these banking panics frequent and regular was that agriculture was a bigger portion of our economy that it is now. So in farm towns, between harvests you'd have panics at the local bank. So there were two options on how to deal with this problem:

1. Lift the Branching restrictions to allow banks to diversify their deposits geographically
2. Create a central bank to inject liquidity into these banks between harvests

As documented in the book "Creature from Jekyl Island" by Edward G Griffith many prominent bankers got involved in the creation of the policy that followed to address this problem. Bankers did not want to the extra competition that would come from having banks branch out, so the central bank was the favored route since it preserved bankers local monopolies.

In beginning (1913) the Federal Reserve only lent to banks through it's discount window where banks could bring "high quality" collateral (usually in the form of government bonds/treasuries) in order to get overnight loans to meet their reserve requirement, which is a fixed percetage of their liabilities they must have deposited at the Federal Reserve (currently 10%). This was for the most part the extent of the Federal Reserves actions till later on.

In 1920 a large Recession took hold in the economy during the end of Woodrow Wilsons administration and the beginning of Warren G Harding. As Harding took office, his Secretary of Commerce (Herbert Hoover) and his Secretary of the treasury (Andrew Mellon) did not see eye to on what actions should be. Herbert Hoover advised that Harding should conduct protectionist high wage policies and also advocated spending increases to which advice Harding ignored and allowed deflation to take hold and unemployment had started going down. The federal reserve had taken little action, cause at this point they had not yet entered something called open market operations.

Come 1924 the Federal Reserve was having problems covering it's operation costs with only the proceeds from loans of the discount window, so it began the purchasing and selling of government debt better known as open market operations. These OMO's had great effects on interest rates and mid-decade began to push interest rates down from these actions which arguably triggers the Austrian Theory of the Business Cycle which I explain in this video.

This leads to the recession of 1929, yet now the president was the former Secretary of Commerce Herbert Hoover. Now that he was the one calling the shots, he conducted the expansionist schemes he wasn't allowed to under Harding and Coolidge. Having increased spending to historical highs, enacting the smoot hawley tariff, and establishing informal cartels in most industry to prop up wages; the economy had only worsened unlike in 1920 which saw a relatively speedy recovery.

As things get worse, a Charismatic contender from the opposing party comes along calling Hoover out and extravegant spending and intervention. This candidate, Franklin Delano Roosevelt, wins handidly and yet increases the spending and intervention well beyond his predeccessor (sound familiar).

At this point the rest is history, but now you have a foundation in where the Fed came from, now let's talk about their dual mandate.

The Federal Reserves Dual Mandate

The Federal Resere has dual Mandate to Carry out...

1. The Pursuit of Price Stability
2. The Pursuit of Full Employment

So let's see their score card since 1913...

- Recession in 1920 w/ double digit inflation
- The Great Depression in the 1930's one of the most dire economic event in history
- Major Rationing and Price Controls during World War II
- Intense Stagflation in the 1970's
- High Interest Rates in Response to Inflation in the 80's
- Dot Com Bubble at the turn of the Century
- Housing Bubble in 2008

Let's also sprinkle on a series of mini recessions in between all of that... although to be fair many of those recessions may be over-pronounced due to how GDP is calculated and the effects of deflation, for example the 1870's was known as a long depression but was actually one of the most robust periods of growth in the country. So when looking at a recession one must take a look with a critical eye.

Although, one can clearly see even if the federal reserve was the benevolent overseer of the economy with which it's avocates paint it as, the concept of price stability is a flawed one. Often price drop due to productivity increases as I explain in this article on deflation, this is a great thing that you can now buy the same goods for lower prices and have more to spend elsewhere in the economy. Although when the fed conducts policy for price stability it uses a method called inflation targeting, which very often is keyed to s statistic called CPI, the Consumer Price Index.


What is the Consumer Price Index?

By current day definitions, we look at inflation as an increase in the prices around us and the Keynsian/Monetarist Orthodoxy believes that a moderate amount of inflation is necessary so the federal reserve should target it at some arbritrary number like 3%. So how do we know how much price inflation is? We use CPI which takes a basket of goods and measures it's month over month price increase, so if CPI is up 3% then the basket of goods has increased in price 3%.

So what is in the basket of goods?

We take all the goods that an AVERAGE purchase purchases using the AVERAGE price from many urban cities

There are many obvious problems with the calculation of this number

- Who is this average person? How do we know what goods they buy?

- If we did know what good, don't those good change over time, so the basket of good must change over time as well which you might remember in any science class is a problem, cause if you constantly change your control variable your information is useless.

- Don't prices even differ in the same city, and what about replacement goods, if a price goes up of one good I may just replace it with another good essentially negating the effect of the price increase in my daily life.

- Also how about regional cultural difference, I imagine the prices in New York will be higher than prices in Detroit, and also the brands of goods and specific good will change due to regional cultural difference.

This all hints at the fundamental problem with all Macroeconomic indicators they destroy valuable information needed to understand why certain phenomena occurs. If I see an increase in CPI, sure this tells me certain prices have gone up but without further inspection I don't know which ones and where.

So in General, the Federal Reserve acts like all prices go down and up together uniformly and adjust the money supply to get CPI to hit their target which ignores so many regional factors that it ends up causing regional and microeconomic problems... but as long as those aggregate numbers like CPI and GDP look good, right?

For example, what if CPI drops and it's actually due to productivity gains in technology (cheaper laptops), it'll show up in CPI as a drop in price which doesn't fit the Federal Reserves definition of Price Stability so they put money into the economy to push the price back up to hit their inflation target and essentially erase that productivity gain. If this had not occured, the savings for people from that productivity gain could of been use to buy other goods which would allow more sectors of the economy to grow. Instead all prices have gone up, and generally wages move slower than consumer prices so if prices are increasing wages arn't increasing fast enough to keep up for a net loss. Vice Versa, in a deflation prices more down faster than wages move down, for example if prices dropped 20% and wages drop 11%, you're actually able to buy more stuff which will then again re-stimulate the economy.

Of course the Federal Reserve would never let prices drop for political reasons which I explain in the Deflation article I linked to earlier.

How about maintaining Full Employment?

Another bizzarre goal, cause for a economy to have a healthy transfer of resources from growing industry from a matured industry you'll have some frictional unemployment. For example as the industry for audio cassette manfuacturers died down unemplyment had to come from that industry before those jobs got replace with jobs manufacturing Compact Discs and other goods. So it's not neccessarily imperative to force the economy to constantly have little to no unemployment, (usally they have an arbritrary target). So by injecting money into the economy resources get diverted from transitioning industries into something else which may or may not be sustainable such as New Internet Start-ups or New Housing Construction, get the picture. It's not that the money wouldn't of been invested, it just would've been invested somewhere else that was sustainable. So if jobs get create in an unsustainable industry instead of an sustainable industry their may be an increase in jobs and consumption until it's realized that the job was unsustainable (AKA a recession).


Bottom Line:

While historically it has been shown that an economy can thrive without a central bank (early 1900's canada) or thrive during deflation (1870's USA) we still insist we cannot exist without a Central Bank who's mandates contradict basic economics who operate based on statistics that tell them very little about what is actually going on it the world. Maybe it's time we start taking economics and history a little bit more seriously...

Summarizing Jorg Guido Hulsmann's Lecture on Deflation

Summarizing Jorg Guido Hulsmann's Lecture on Deflation

by Alex Merced

Listen to his Mises U Lecture on Deflation

One of my favorite topics and debates is the Inflation/Deflation debate, of Hulsmann has written extensively about putting him in my top 5 misesians (Murphy, Block, Woods, Hulsmann, and Salerno). This year his lecture was recorded much better than last years, so I was able to gleem much more of the finer points. Ok so let's sum up his argument about why growth can occur during deflation...

Three Examples Of This Good Deflation in the US:
1839-1843: Had Deflation in which unemployment remained near full employment
1870's: Where you had sustained deflation, and the most steady and robust growth in American History
1920's: Where the country went into recession, and allowing it deflate led to a speedy recovery unlike 1929.


(NOTE: In his lecture Hulsmann consciously decided to stick to the current mainstream definition of deflation as drops in the price level, not the typical austrian definition as a drop in the money supply, there is a difference.)


How do Prices Drop from Productivity Gains:

A pully system makes accomplishing a task easier by extending the distance of which I must exert force. So for example to pick something up 3ft I may have to use a force of 10, but if I use a pully and pull 10ft worth of string and only need to use a force of 3, so now with a force of 10 I can pull the block up 9.3ft. As you can see, by extending the distance the productivity has increases, and the structure of production works the same.

For Example Let's Use Hulsmanns Example of the Farmer

Structure One - The Farmer Plows the Field by Hand

Structure Two - Someone Raises the Horse -> The Farmer Uses the Horse to Plow the Field

Structure Three - Someone Mines Steel -> Someone Assembles Parts from Steel -> Someone Assembles the Parts into a Tractor -> The Farmer Uses the Tractor to Plow the Field

So looking at these three it should be obvious structure one would be the most expensive structure of production. In this scenario the farmer would either lose a lot of time plowing the fields himself, or money having to hire many worker to plow for him, so the end good would be more expensive. Although, in structure three, the farmer may be able to plow the whole field by himself in little time with the tractor so his goods would be cheaper. So as the structure of production grows, production becomes more productive, which means the goods can be cheaper, this is the kinda of productivity based price deflation we see in technology all the time.


Next Point: What if deflation occurs cause changes in the supply or demand for money? (IE people want to save more)

In an Equity Based Economy (people + businesses pay cash, little to no debt in the economy) - Producers who do not anticipate the price deflation with lose money when they can't sell their goods at the previous market price. In order not to lose money again the producer will renegotiate the costs up the structure of production making the whole structure nominally cheaper to adjust to the deflation to maintain the same profit margins. If the producer does anticipate, he may stay out of the market to not lose money and wait till some people have in order to negotiate the costs of structure of production. At the end of the day, after adjusting the structure the producer and all the higher stages of production will still have a similar margin of profit after adjusting.

In a Debt Based Economy (people+ businesses incur debt to purchase goods) - This is more painful since the debt's nominal value doesn't automatically go down with prices, so it's difficult to service the debt on the slimmer profits. Although, just like the structures of production, if the lender and borrower both want to continue on they'll renegotiate the principal (original money lent) of the loan probably at a higher rate of interest so it can be serviced in the equilibrium price level. Although not all lenders have the foresight to renegotiate so there will be a period of massive bankruptcy of borrowers and lenders purging the non-sustainable debt leaving the economy with a sustainable foundation. In the end though, new market entrants will surface with the lower costs of business to continue the structure of the production.

Final Point: Why do the elites and powerful fight so hard against deflation?

People need resources to gain power, those who are most powerful and elite in society more than likely have incurred lots of debt in the process of attaining that power. If deflation takes hold, while it doesn't change the overall structure of the economy it does ravage the elites and powerful as they go bankrupt not being able to maintain their large debts, and brings upon a proverbial political power shift to those who saved and acted responsibly under their reign of power.

Conclusion

Not only does deflation not destroy an economy, it actually can make it more robust as seen by historical evidence linked to at the the top. Deflation truly threatens the elite who's policies and reign causes the massive inflation that the deflation corrects, so it plays a very healthy role in making sure young fresh responsible people move up the power ladder while the old corrupt irresponsible power of old is punished for their mis-use of power and leverage.

US Economic History from 1913 to Today in 10 Minutes