Some Thoughts
Jude Wanniski
December 23, 2004


From: Ben.S.Bernanke@***.gov
Subject: Re: Some thoughts
To: Jude Wanniski < >

From Ben S. Bernanke, 10:54 am 12/23/2004


Jude Wanniski   <>                                               
To: Ben.Bernanke@* * * * *.gov          
Subject: Some thoughts            12/23/2004 10:24 AM                                                            
Dear Ben:

After thinking about our exchange and re-reading your essay, I think I have a way of clarifying what I have been trying to get across, re the difference between "contraction" and "deflation" on the one hand and "expansion" and "inflation" on the other. There are in the Keynesian and monetarist demand models no such distinctions, at least as far as I can tell, and I only learned them by accident by happening upon Von Mises "Human Action," where he was explicit about the differences. (I first read the book in 1982.)

In a contraction, prices will fall because there is suddenly an increase in the supply of goods relative to demand, arising from a non-monetary event, perhaps an unexpected rise in tariffs, taxes or regulatory burden, at home or because of global conditions. Relief from contraction cannot be found by application of the monetary levers available, but the government can adjust tariffs, taxes or regulatory burdens to bring relief.

In a deflation, prices will fall because there is a monetary error being made by the monetary authorities, i.e., not supplying the liquidity that the market needs to support the increase in economic activity that has developed because of some positive non-monetary event. The money stock has to adjust to enable the economic expansion to proceed, which means each unit must do more "work." In order to end a deflation, fiscal measures will not work, but monetary adjustments that add liquidity will bring relief. The relief is felt by debtors, who are then able to meet contractual liabilities to creditors with a money that has the original purchasing power.

In an expansion, prices (and wages) may rise if there is a sudden, temporary increase in the demand for goods arising from society's need to produce more than it had anticipated. It will take time for economic units to gear up to meet the extraordinary demand (perhaps a war). Typically, thegovernment will recognize this rise in prices for what it is and not take action to subdue the price increases. An appropriate measure would be an increase in interest rates by the central bank, which would subdue those parts of the economy that do not have a national priority, and would be more efficient than wage and price controls.

In an inflation, prices and wages rise because the central bank has erred in supplying more liquidity than the economy needs or wants, or has failed to withdraw liquidity that had been needed at an earlier point in the economy but is suddenly in excess. Relief from an inflation cannot come through fiscal or regulatory actions designed to slow the economy or by raising interest rates to slow the economy. These inappropriate tools will furthur decrease the demand for liquidity and bring about a further declinein the money's purchasing power. The only relief is to withdraw the surplusliquidity to nip an incipient inflation before it runs through the entire general price level, or to increase the demand for liquidity in the system in a way that restores the purchasing power of the currency to its originallevel.

 From this formulation, you can perhaps see what I am driving at when I sayyou are using the wrong tool to achieve your objective, and are in fact moving further away from your objective.

Does this help?

Here you will find the most relevant passages in Von Mises, whose "Human Action" is available in its entirety at, with an index that enables the reader to go to the sections of interest.

Expansion produces first the illusory appearance of prosperity. It is extremely popular because it seems to make the majority, even everybody, more affluent. It has an enticing quality. A special moral effort is neededto stop it. On the other hand,  contraction immediately produces conditions which everybody is ready to condemn as evil. Its unpopularity is even greater than the popularity of expansion. It creates violent opposition. Very soon the political forces fighting it become irresistible.

Fiat money inflation and cheap loans to the government convey additional funds to the treasury; deflation depletes the treasury's vaults. Credit expansion is a boon for the banks, contraction is a forfeiture. There is a temptation in inflation and expansion and a repellent in deflation and contraction.

But the dissimilarity between the two opposite modes of money credit manipulation not only consists in the fact that while one of them is popular the other is universally loathed. Deflation and contraction are less likely to spread havoc than inflation and expansion not merely becausethey are only rarely resorted to. They are less disastrous also on account of their inherent effects. Expansion squanders scarce factors of productionby malinvestment and overconsumption. If it once comes to an end, a tediousprocess of recovery is needed in order to wipe out the impoverishment it has left behind. But contraction produces neither malinvestment nor overconsumption. The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the partof discharged wage earners and the owners of the material factors of production the sales of which drop. No protracted scars are left. When the contraction comes to an end, the process of readjustment does not need to make good for losses caused by capital consumption.

Deflation and credit restriction never played a noticeable role in economichistory. The outstanding examples were provided by Great Britain's return, both after the wartime inflation of the Napoleonic wars and after that of the first World War, to the prewar gold parity of the sterling. In each case Parliament and Cabinet adopted the deflationist policy without having weighed the pros and cons of the two methods open for a return to the gold standard. In the second [p. 568] decade of the nineteenth century they could be exonerated, as at that time monetary theory had not yet clarified the problems involved. More than a hundred years later it was simply a display of inexcusable ignorance of economics as well as of monetary
history. <[10]>[10]

Ignorance manifests itself also in the confusion of deflation and contraction and of the process of readjustment into which every expansionist boom must lead. It depends on the institutional structure of the credit system which created the boom whether or not the crisis brings about a restriction in the amount of fiduciary media. Such a restriction may occur when the crisis results in the bankruptcy of banks granting circulation credit and the falling off is not counterpoised by a corresponding expansion on the part of the remaining banks. But it is not necessarily an attendant phenomenon of the depression; it is beyond doubt that it has not appeared in the last eighty years in Europe and that the extent to which it occurred in the United States under the Federal Reserve Act of 1913 has been grossly exaggerated. The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises--not only those which are doomedat any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paidback, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict the scope of their activities. But there is no means of avoiding these secondary consequences of the preceding boom.

As soon as the depression appears, there is a general lament over deflationand people clamor for a continuation of the expansionist policy. Now, it istrue that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. Every firm is intent upon increasing its cash holdings, and these endeavorsaffect the ratio between the supply of money (in the broader sense) and thedemand for money (in the broader sense) for cash holding. This may be properly called deflation. But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production -- both material and human -- have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they [p. 569] abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thusany attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.

Even economists often failed to comprehend this concatenation. They argued thus: The structure of prices as it developed in the boom was a product of the expansionist pressure. If the further increase in fiduciary media comesto an end, the upward movement of prices and wages must stop. But, if therewere no deflation, no drop in prices and wage rates could result.

This reasoning would be correct if the inflationary pressure had not affected the loan market before it had exhausted its direct effects upon commodity prices. Let us assume that a government of an isolated country issues additional paper money in order to pay doles to the citizens of moderate income. The rise in commodity prices thus brought about would disarrange production; it would tend to shift production from the consumers' goods regularly bought by the nonsubsidized groups of the nationto those which the subsidized groups are demanding. If the policy of subsidizing some groups in this way is later abandoned, the prices of the goods demanded by those formerly subsidized will drop and the prices of thegoods demanded by those formerly nonsubsidized will rise more sharply. But there will be no tendency of the monetary unit's purchasing power to returnto the state of the pre-inflation period. The structure of prices will be lastingly affected by the inflationary venture if the government does not withdraw from the market the additional quantity of paper money it has injected in the shape of subsidies.

Conditions are different under a credit expansion which first affects the loan market. In this case the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at whichthey can remain only as long as the credit expansion goes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.

While the boom is in progress, there prevails a general tendency to buy as much as one can buy because a further rise in prices is anticipated. In thedepression, on the other hand, people abstain from buying because they expect that prices will continue to drop. The recovery and the return to "normalcy" can only begin when prices and wage rates are so low that a sufficient number of people assume [p. 570] that they will not drop still more. Therefore the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates.

Only when the recovery begins to take shape does the change in the money relation, as effected by the increase in the quantity of fiduciary media, begin to manifest itself in the structure of prices.

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