Originally published November 16, 2001

It has been said, and if not, let it be said here today that the sound money principle as defined by Mises¹ is a sovereign protector of the system of private property - itself charged with the protection of civil liberties essential to the individual's freedom, as well as of market processes responsible to his prosperity. And to the extent that a society with its liberties intact is a just society and a just society a moral one, liberty is sovereign to a strong moral code.

Isn't that our connection between money and morality? Doesn't sound money help us to achieve liberty, and liberty in turn help us become a just and moral society?

If so, to the extent that the fiat monetary regime undermines the capability of free market mechanisms and overrides their role in the allocation of scarce resources, the system of private property is clearly compromised, since it is based on the idea that market prices determine what should be produced for the economy. To the extent that it is not a market economy, meaning an economy governed by (an efficient) price mechanism, it is a planned economic system.

Accordingly the usual mismanagement of a planned economic system, dubbed moral hazard, will result in massive unemployment once the ephemeral impetus to its goal toward full employment ceases to provide effective stimulus. Then the true costs of such a system will either reveal themselves or be deferred by the administrators of the system, who will mastermind a new set of variables that will respond to their stimulus, and which will fully employ the nation's economic resources.

Sooner or later, such an economic system breaks down. Not because the guys at the Treasury or Fed run out of ideas, but because their ideas no longer work. Why, how could they keep working? If they could then the system of private property is indeed obsolete. For it is the market mechanism that has until today been thought to best decide how to allocate the nation's scarce resources. Today, it isn't the market that provides us with cheap energy, cheap credit, and cheap foreign goods. It is economic "policy" that does, which is a direct rejection of the sound money principle, the consequences of which history has decided the same way it is deciding today.  - Ed Bugos

The Money is No Good
A rejoinder to The Deflation Monster, by Jude Wanniski (October 6, 2001), and all deflationists, as well as an update on the inflation vs. deflation debate.

CRB Index 1995-2001	Gold prices 1995-2001

In describing the sound money principle Ludwig von Mises says that there is just one basic condition that needs to be met, and to make it easy for critics of the principle to grasp he quoted it in both the affirmative and negative:

"Thus the sound money principle has two aspects. It is affirmative in approving the market's choice of a commonly used medium of exchange. It is negative in obscuring the government's propensity to meddle with the currency system." - Mises, on the principle of sound money, pp454, the Theory of Money and Credit

In modern society you cannot have the first without ensuring the second. It sure would be nice to define everything in positive terms, but we can't do that with rules. I wonder if the sign: "Please walk on cement" would be as effective as the sign on someone's lawn that says, "Please keep off," especially if you're dealing with insects with an appetite for grass.

At any rate, Professor Jude Wanniski without question violates the tenet of the sound money principle by denying the market its choice for a commonly used medium of exchange (which is the case when you fix exchange rates), and also by sponsoring the government's propensity to meddle with the currency system.

So today we are going to show you why we believe that a true deflation outcome is not possible unless either Professor Jude Wanniski realizes his and Robert Mundell's dream, or until "after" the inflationist agenda our economic system operates on has broken down. Yes we have had inflation, but it has not yet manifested in our money because it (the inflation) hasn't yet broken down.

By the time you're finished this article, I'm certain you'll understand what we mean by that statement.

Deflation Bogeyman
Undoubtedly many symptoms of deflation are with us today. Symptoms are how the neighborhood Doctor guesses at what his patients have come down with. Doctors, as well as mechanics or your technical support staff, and would you believe even economists unfortunately do not have a convenient gadget that reliably reveals what the problem is. It usually comes down to a process of elimination. That is brutally primitive indeed, but true.

What's more, there is no other way until we have developed very advanced artificial intelligence, which mere existence would scare the pants off most people, yet which would probably work the same way, just faster.

But what if a particular symptom is shared by more than one kind of illness? Or, in this case, what if some of today's deflationary symptoms are shared by causes other than deflation? How does the analyst (or Doctor) make his diagnosis then? Well, for starters, once facts have been collected, he or she could try to explain away some of the less likely sources or causes. This isn't easy to do because it means the analyst must be objective.

What other explanation, for instance, could there be for a decline in the dollar price of certain goods, "besides" deflation? Could there be more than one?

Sure there could. If something other than deflation came along and swept the value of the dollar up against every other currency in the world, what might happen to the price of commodities denominated in dollars? Couldn't the foreign exchange value of a currency import deflationary pressures, as easily as it could inflationary ones? The short, short answer is yes. Thus, the analyst is faced with trying to determine today whether deflation is the cause of the dollar's ascent, or whether other forces better explain the dollar's ascent, which in turn imports deflationary like forces. This is so important because one is natural, for lack of a smarter term, and the other must be, well, reversible.

Nevertheless, the steadfast deflationist (already failing in objectivity owing to title) would say that the dollar is up against other fiat currencies as well as against commodity prices due to deflation. To which we might reply that the level of trickery alone (symptoms of a managed dollar), explicit by dollar policy today, indicate that a managed dollar is behind the ascent in the subjective, and perhaps objective³, exchange value of the dollar. But then, we would be dubbed conspiracy theorists.

Certainly, deflation is a force that tends to manifest in a rising objective exchange value of money (declining prices for commodities exchanged for it) just like inflation is a source of an ultimate decline in the objective exchange value of money. Further, both inflation and deflation are likely to manifest in foreign exchange contracts, but on a relative basis. Thus, it is tempting to conclude that if these symptoms of deflation show up in both the objective and subjective exchange value of money that deflation must be the cause.

In October, Jude Wanniski⁴ took it upon himself to claim victory in an at least a decade long struggle to prove once and for all that deflation was among us, has been ever since he warned us so in 1995, and in fact has been the force that the Fed has been fighting all along. Thus, we consider Mr. Wanniski to be a good representation of the deflation argument.

He argues that this deflation has been spreading through Asia, Russia, Brazil, the US, and now Argentina and Zimbabwe. He claims that Japan is on its 12th year of deflation, referencing the doubling of the yen against the dollar since then. And his most valuable indicator is the relentless bear market that gold prices have been in since.

He is saying that the declining dollar price of gold indicates that what is behind these economic collapses is deflation. Pretty convincing but I like our argument better.

Currencies Collapse From Inflation not Deflation
Currencies from Russia to Asia to South America are not collapsing due to deflation, but rather to the weight of their own relentless inflation policies, which examples they have imported from the Federal Reserve. If this were true then those particular currencies would decline against both gold and the dollar, which they did. But why was it the dollar that was preferred to gold over this period? Before we try to answer that, note that in some cases such as Argentina and certain Asian countries that are indeed dollarized and indebted in terms of the dollar this does not apply.

The consequence of poorer monetary policy abroad has been a boon for the value of the dollar this past decade, and boy did Wall Street learn how to recycle all of that fresh dollar demand. The more dollars that were demanded, the more were created, as deposits held inside of the United States were pyramided into the largest credit bubble ever seen. Here is a visual:

All of these dollars are backed by the credit in the chart on the right. They are in demand because they offer an investment premium during the typical cyclical upturn in the US credit cycle, not for the value of their convertibility. It is the kind of demand that spurs inflation not deflation, and it is the kind of demand that drove this credit bubble. Let's expand on the topic.

Unbeknownst to Jude Wanniski's Wall Street clients then, are that there are other reasons, which perhaps better explain the dollar's strength than deflation.

The Inflated Investment Premium
Recall in last week's GIC how we showed that the dollar is in a primary down trend against the yen, and has been topping against the euro since September 2000. The dollar's strength has predominantly been against the secondary currencies, over the last few legs of the recent bullish sequence in the dollar index, where inflation rates are generally higher.

That said recent rate cuts from the ECB portend rising rates of inflation in Europe, and perhaps a renewed bull leg for the dollar over the euro. That situation needs to be monitored closely. By the way, has credit money ever been legal tender before? I would love anyone's views on that (mailto:gold@goldenbar.com).

Moreover, we showed that in the long run there is an inverse relationship between the relative growth rate of an economy's money supply and the Forex value of its currency, meaning that the higher one is, the lower the other one should be. Thus the country with the lower relative inflation (in money supply) over an extended period of time should be the one with a stronger currency, which should transmit net deflationary pressures, or deflation like symptoms, all else being equal.

Note the tendence for US Money Supply to grow faster over the long term;
Compare that trend to the FX value of the Yen over the long term

We also showed last week how exchange rates are determined in the medium term by capital flowing across the border seeking an optimum ROI (return on investment). This is the cyclical component to currency movements we discussed in relation to an investment premium.

And in the short run, we should all know that between dollar policy and US economic policy, not only certain FX behaviors are managed, but also that certain commodity prices are managed. We know that the Department of Energy sells oil when prices are high and buys it when prices are low, for instance, but some of us suspect too that they attempt to influence these prices to achieve broader aims.

The point is that the dollar did not begin its cyclical rise in 1995 as the consequence of any deflation, but because foreign exchange participants attached an increasing investment premium to the dollar.

I bet that's "a new one on JW" as well (private joke).

For instance, I believe it was George Soros that observed that one little thing, which may have started the whole ride, and which he does so well. In 1994, the "volatility" (collapse) in the long bond was perceived to be the result of an SEC regulation requiring U.S. banks to mark-to-market their bond portfolio each quarter. So they rigged it so that their income statements would no longer show losses when bond prices declined, unless the bank sold its bonds. This way, bank stocks quickly became a hot item in foreign accounts. Consider this to be another policy trick.

Ad-hoc policy maneuvering like this of course explains why the enormous inflation of the period was drawn to financial assets, or perhaps why the financial markets prompted so much inflation, rather than the commodities. Fed policy adapted to the new game quickly, and it learned how to create demand for dollars. Alan Greenspan became a market mover.

On the other hand, it is also entirely possible that chance alone "could" have brought about the unique confluence of events that sent the dollar and financial markets into a feedback loop where a rising expected return on investment in US assets both inflated, and was inflated by, the growth in money supply, while gold prices just sunk and stunk.

I guess we can argue this point until we are red in the face that the dollar benefited from a rising investment premium during that time, and I presume that few would disagree. Yet, despite the four consecutive back-to-back double-digit gains in the S&P 500 index during this period the Jude Wanniski's of the world say deflation is indeed what has forced certain foreign currencies down against the dollar, that there must be no other significant explanation for the fact. Poppycock.

What is Inflation & Deflation?
So the specter of deflation is inexorable, and ever present in the prognosis of current economic developments here and abroad. It follows, however, that if most people do not understand inflation despite its undeniable permeation in nearly all aspects of our lives, then the rare deflationary episodes in our plight this century cannot help us to understand the mysterious deflation monster any better.

The casual observer of economics understands inflation to be a rise in the consumer price index, and deflation to be its anti-thesis. In fact, the whole topic of deflation is seen to be the anti-thesis of inflation, as though deflation naturally follows inflation.

It can if the quality of the monetary unit isn't sacrificed.

As long as economic growth is stimulated through the equivalent of monetary debasement, it is not likely that the economy will ever have real deflation UNLESS either a new monetary choice is preferred, or something else comes along to change the nature of that money, including either devaluation if it is legal, or international agreement.

While accusing the Fed and US Treasury of pursuing the policies of deflation, Jude Wanniski claims that both inflation and deflation represent a decline in the monetary standard. At first, his definition of deflation was fairly correct. He said that deflation was a significant undersupply of money relative to demand (for money). But then he started to mix up deflation with its symptoms, and seemed to conclude that deflation represents a decline in the monetary standard. This is at best a variation of correct.

To be sure it wasn't clear from his writing if this is what he meant but quoting Robert Mundell who says that "Inflation is a decline in the monetary standard," he alleges that deflation is also a decline in the monetary standard, due to the influence it has on defaults and bankruptcies in the US and anywhere else. Thus, he argues, we ought to rid ourselves of the evils of both inflation and deflation, through policy, which will presumably work once we understand them in this way.

Despite the fact that he endorses our argument about the quality of money, he does not seem to be able to grasp the proper reason for its deteriorating quality, nor does he seem to grasp that money has a broader function than its role as a medium of exchange. In addition, he assumes that money supply is neutral, is independent of demand, and yet should grow in proportion to economic output. It is our intent to discuss the falsity of those assumptions momentarily.

But first in writing The Theory of Money and Credit, Ludwig von Mises made a special point of avoiding a discussion of either inflation or deflation on the grounds that there is a serious difference of opinion on its precise meaning, and that therefore it would be unscientific to use such words "where a sharp scientific precision of the words is desirable," in everyday discussions of economic and currency policy.

Since his point was made (that he could write an entire book on money and interest without referring to the words inflation or deflation), he offered up his own definition anyway. According to Mises (pp 272; The Theory of Money and Credit):

"In theoretical investigation there is only one meaning that can rationally be attached to the expression inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange value of money must occur. Again, deflation (or restriction, or contraction) signifies a diminution of the quantity of money (in the broader sense), so that an increase in the objective exchange value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange value of money did not alter could hardly ever exist for long."

So much is said in that paragraph that one could go away for a year and learn all about the topic of inflation, come back to this paragraph, and find new truths to be revealed. Ludwig von Mises was ahead of his time, but he preceded the currently unprecedented floating global fiat monetary experiment, which began with Nixon's closing of the gold window, officially in 1973.

I am personally certain his definition of inflation in terms of the subjective exchange value of money would have become more advanced were he alive and well today, and much clearer in relation to our current predicament. Certainly, the import and export of inflation/deflation is not new, but how and whether the floating exchange rate between two countries using credit money, and engaged in freer trade, affects the objective exchange value of money must be (new).

To be sure, new economic theory will probably emerge from this experiment showing how the government, Fed, and entire global banking system achieved feats (good and bad) never before accomplished in the history of mankind.

But this paragraph also has other significance to us besides cleaning up our definition of inflation and deflation.

It is an important point that either inflation or deflation is constantly going on, and even more important is Mises' observation that a stable purchasing power for money is unattainable.

It is true, but good luck in trying to measure it. Still, Wanniski's model seeks to fix the objective exchange value of the dollar against gold. This way he hopes to cure these "manifestations" of inflation and deflation, but by allowing (actually promoting) growth in the monetary aggregates the model, as he does, overlooks the causes of both. Monetarists believe that the money supply is a neutral variable and that it is the rate of interest, which causes inflation or deflation, thus completely disregarding the quantity influence of money, which Wanniski embraces when it is convenient.

And the odd thing about that contradiction is Wanniski recognizes that deflation is a consequence of, or related to, a mismatch between the demand and supply of money but he doesn't seem to acknowledge otherwise the broad social and economic effects of a growing money stock, preferring to hide beneath the assumption that demand for money must be rising independently of its supply.

In asserting that it is someone's job (like a central bank) to ensure a match between the demand and supply of money it is assumed that the demand for money, and economic demand measured by GDP are the same, and that they are independent of the quantity of money supplied.

But that isn't quite correct. For one, the calculation of GDP includes the interaction between expanding monetary aggregates and real output, as well as net economic demand resulting from the expansion in monetary aggregates. Didn't the financial industry expand enormously over the past decade? Sure it did because new markets developed that were necessary to stabilize the massive inflation, and new ventures arose out of the reckless supply of easy money for the taking. Entire industries were erected from the era of easy money that specialized in creating demand for it.

The only thing that stimulates the demand for a lot more money is a system that is based on an inflationist agenda.

Money in this economy is created when someone wants to borrow for something, be it for business investment or for consumption. The latter is not normally originated out of the demand for money, but it surely adds to it. Not a moment after spending the money, securities for sale, which will be bought by one of the banks that deals with the Fed, or financed by the Fed. Demand for that money will be determined by a suite of variables independent of the decisions that went into its creation, such as yield and quality. And it is money because it is fiduciary media that is counted in the monetary aggregates.

But it isn't good money. It's increasingly bad money, and there's too much of it.

After a thorough analysis of Professor Wanniski's argument we have determined that there is agenda inherent in his rhetoric. Just to clear the air, we do not have any personal animosity towards Mr. Wanniski. Our animosity stems from the fact that he operates under a disguise, and that there is a goal to his work, which explains its inaccuracies.

Having reportedly met with Treasury Secretary Paul O'Neill, and all the other names he likes to drop in his writing, it is apparent to us that he is vying for a spot as a player in whatever changes our global monetary pirates have in mind. Were it not for that we would not need to refer to his name, only his arguments.

Are Defaults Due to Inflation or Deflation?
His goal for instance explains (his symptoms?) why it is he defines Japan's monetary plight in terms of the yen and all of the others in terms of the dollar, rather than the Brazilian Real, Russian Ruble, or the Zimbabwe dollar. Japan uses the dollar as its primary monetary reserve as well.

I remember reading about Russia's "inflation" crisis throughout the nineties, which makes sense since the Ruble was in steep decline post the failed Soviet full employment doctrine - communism.

Sure, dollars increasingly were becoming the preferred choice, but in all cases, their currencies collapsed as a consequence of a long running unsustainable inflation that broke down. The result was increasing prices in terms of the most common medium of exchange, and simultaneously, a preference for a new medium of exchange.

Let us extend that by saying, hypothetically, were the dollar foreign exchange rate to collapse under the weight of excessive money supply, and the world went to a gold standard, there would be inflation in terms of the dollar and deflation in terms of gold, as was indeed the case throughout the seventies.

But since the dollar stayed on, our perspective is through that medium. Should the dollar go away for good, our future perspective will be from another currency. Thus Wanniski is already assuming that these countries are going to become dollarized.

Additionally, it isn't deflation that is causing the rise in national default and bankruptcy rates. It is indeed tempting to conclude, as does Mr. Wanniski, that both must be symptoms of an oncoming deflation if not its cause. But they are neither.

On the contrary, we argue that they are a direct consequence of the aging monetary boom, which began post Reagan, and a central bank policy that continues to set fire to a faltering credit bubble, mature credit cycle, in particular, bad investment policy.

In other words, it isn't "not enough money" that is causing the problem but "too much money," as usual.

Had monetary policy been kept neutral throughout the past few years then there may have been deflation, for various reasons, but it hasn't and consequently there is not a single question in our minds that the cost of the failure of this entire monetary experiment is going to be born by the dollar. Of course the Federal Reserve and US Treasury will deny it, "they" created it.

Let's get real here. Defaults are not happening simply because money is now scarce, but because too much money continues to chase after bad money (or uneconomic ventures). Even today, while default rates are rising, American financial institutions are lending more and more money, thus fueling the poor decisions going into making loans. And as David Tice says, the only reason that default rates are not higher is because:

"This aggressiveness has increased the denominator in the loan default ratios, making it appear that credit quality is not falling as quickly as it really is, as newly extended loans don't default that quickly."

This of course begs the question that if they ended their easy credit policies wouldn't the money stock contract, as the consequence of rising default rates, which would indeed bring on deflation?

Whoa horsy, what on earth could persuade them to tighten credit, risk of bad loans? Didn't we just say that they are easy, largely to keep those bad loans liquid? But it is more that that.

The fact that a contracting money stock is deflationary assumes that we are talking about money when we discuss the US dollar.

What is Money?
But what if in the end the markets determine that the US dollar is not really money? It is for all intents and purposes, because it functions as a medium of exchange and unit of account. But Mises says that credit money comes into being out of a temporary suspension of full convertibility. While the dollar is exchangeable for anything at the moment that does not mean there is a guarantee it will for the foreseeable future. Full convertibility ended with Roosevelt in 1934, and whether it is arguable or not, we contend that this money represented by the dollar today came into being by a breach of the constitution, if not the law.

Since then the only guarantee of convertibility lies in the capability of the institutions charged with our full faith and credit to guarantee all debtor contracts that support the issue of this liability money. So that guarantee depends on the Fed's viability, which in turn depends on how effectively they can inflate, something, anything…

Ironically, one of the things that can prevent the breakdown in the value of the dollar if only temporarily, and at least in theory, is the belief that deflation is setting upon the economy. If participants believe that the consequence of the decade's monetary boom is deflation then they will act accordingly, which, as we ought to know will invoke the old savings paradox, where individuals seeking to protect themselves from deflation will hoard cash balances and collectively cause a deflation.

The wildcard here today is in what they will choose as money. The dollar is not fully convertible into anything, plainly abundant and over-owned, is losing its investment premium, has claims against it, and thus falls short in its role as a store of value.

Our guess is that if the US credit cycle is structurally mature then so is the value of the dollar, in whatever role it played while the cycle was in its boom phase. In other words, the dollar's fate is not only tied to the stock market, but also to the credit cycle.

The bust sequence of monetary/credit cycles since the gold standard was actually abandoned (in 1934) has been bearish for the dollar, and we see no reason why this much bigger bust is any different.

The one exception was the post WWII recession, but then that was because Bretton Woods required the world to own more dollars.

Which brings us back to the Polish named economist. In The Deflation Monster, Jude Wanniski quotes Mises and criticizes JM Keynes as if he were a proponent of sound money himself, but nothing could be further from the truth. In fact, it is the same trick that Keynes used in criticizing the 1929 Fed for being too tight. While it appeared that he was opposed to the Fed and favored a gold standard, the truth was in the opposite of both illusions.

Jude Wanniski and Robert Mundell are proponents of fixity, or fixed exchange rates. They advocate a variation on the Bretton Woods international monetary standard where the United States would control but not monopolize the agreement. That system was unsound, as is any monetary system contrived by the State to oppose market forces. Near the end of his article, Wanniski says that:

"In a new (monetary) regime, we might expect the United States to get more say in its management than other member states, but not a monopoly power, which is what it had in the Bretton Woods system. I believe Mundell could design such a system between breakfast and lunch, as he has been thinking about it for decades."

I'm certain he has.

Thus, his idea is for an immoral gold standard, much like the one that Keynes helped develop the Bretton Woods system around. Although he writes that he is bullish on the price of gold, he is not bullish on what gold really stands for. If he were he wouldn't weigh down the sound money principle with more policy.

Our suspicion of Mr. Wanniski is in no small part ground in the convenience that declining gold prices present to his argument.

Indeed I wonder how smart his deflation argument would look if it were true that the world's central banking cartels have been manipulating the dollar/gold ratio? That one tiny truth would have to put him in the inflation camp faster than you could say I. What then would be his argument for deflation, or anyone's for that matter?

Wanniski Conveniently Doesn't Get It
So what can we make of current circumstances, where the nation's most revered and popular economists seem to be engaged in some form of agenda?

Make no mistake; Wanniski is a Statist and an enemy to gold in its role as guardian of the sound money doctrine. But his argument is undoubtedly convenient for some interests today. Interests that want to persuade you of the strong dollar, which is the only way they can defer the inevitable… inflation breakdown.

What he wants for gold is already happening, according to GATA, but has been taken advantage of. If this proves to be true (it is true but proving it is another thing) then clearly there is not a little hole in his arguments (which we think might look rather dumb in hindsight, someday).

Ludwig von Mises, for instance, knew full well that the principle of sound money and monetary "policy" are mutually exclusive.

Wanniski is blind to that concept. Moreover, John Keynes, an advocate and early designer of the Bretton Woods monetary system (along with Irving Fisher), preached that the supply of money must keep pace with output. Our Polish economist too preaches this nonsense, which disregards the monetary affects on the computation of aggregate demand, as discussed earlier.

Nonetheless, while completely disregarding the principle of sound money (as defined by Mises) throughout the paper, Wanniski proceeds to quote Mises in the context of one of his rejections of policy altogether in what must be utter ignorance about Mises' views on the subject:

"People labored under the delusion that the evils caused by inflation could be cured by a subsequent deflation… but the statesmen who were responsible for the deflationary policy were not aware of the import of their action. They failed to see the consequences which were, even in their own eyes, undesirable, and if they had recognized them in time, they would not have known how to avoid them." - Ludwig von Mises.

Allow us to complete Mises' thoughts on the subject of State and money from his Theory on Money and Credit:

"Once the principle is so much as admitted that the state may and should influence the value of money, even if it were only to guarantee the stability of its value, the danger of mistakes and excesses immediately arises again."

One of the biggest ironies as pertains to Wanniski quoting Mises is that Supply Side doctrine precludes the individual as a primary actor in the economy, while he is the primary actor in Austrian economic doctrine. According to Wanniski:

"In a supply side model, it is not consumers but producers of goods - those who supply them to the marketplace - who are the primary actors."

This markedly alters one of the main properties that have historically made money what it is, by making its role as a store of value secondary to its role as a medium of exchange, for instance. Consider what Mises says on credit money:

"Yet credit money is not merely an acknowledgement of indebtedness and a promise to pay. As money, it has a different standing in the transactions of the market. It is true that it could not have become a money substitute unless it had constituted a claim. Nevertheless, at the moment when it became actual money - credit money - (even through a breach of law), it ceased to be valued with regard to the more or less uncertain prospect of its future full conversion and began to be valued for the sake of the monetary function that it performed. Its far lower value as an uncertain claim to a future cash payment has no significance so long as its higher value as a common medium of exchange is taken into account."

Doesn't it all make sense that if our money, being credit money, has no value as an uncertain claim to a future cash payment or conversion that it is of prime importance that the state continues to promote its value as a medium of exchange?

Isn't it of prime importance that the credit cycle, stock market boom, and full employment doctrine don't stop so as to put into question the dollar's convertibility?

But then if they continue, great right? Wrong. If the stock market bubble/inflation is the result of growth in the money supply over the nineties (duh) under the auspices of a full employment doctrine then the result will ultimately be the same as it always has been. The longer goes the misallocation of resources through a mostly artificial boom, the greater will be the corrective forces required to re-employ the economy.

Unfortunately, the booms this century and indeed often through history, have been of monetary origin, or the equivalent of debasement. The only thing standing in front of the crystallization of this fact is the Treasury and Supply Side doctrine.

For doesn't Supply-Side doctrine fit conveniently into our current monetary predicament, and doesn't it fit nicely with our belief that we live in a capitalist society? More than perhaps even the highly regarded Jude Wanniski will ever know. For it must be pure ignorance on the professor's part not to understand that Austrian economic theory is based on (individual) human action as the core economic variable, a position that seems diametrically opposite to the one above.

The Inflation Trap
Some time ago we wrote a piece entitled "There is No SafeHaven," where we concluded that the Fed is in an inflation trap, and proceeded to detail seven reasons. Briefly here they are (for a better understanding of each, please refer to above link):

• The Fed's sponge is politically incorrect, and fundamentally disabled.
• Inflation has always existed, but nobody can see it.
• The new dollar paradigm has made the US dollar vulnerable to tight money.
• Vested interests in the cancellation of all debts: U.S. is a debtor nation, as opposed to a creditor nation such as Japan.
• The Fed itself no longer controls the money supply. · The politics of the dollar are stressing the strong dollar policy.
• Lender of last resort model guarantees all debtor contracts.

I think our arguments are more advanced today, but our conclusion is the same, that deflation in the United States is utter nonsense, and impossible. We believe this to still be true and in fact many of the points above have now intensified along with our view that the current deflationary conundrum has been brought on by unsustainable and easily reversible policy that is designed to actually control the massive inflation agenda.

The one where we have proven wrong so far is that the politics of the dollar stressed out a year ago. Clearly, we have learned since then how powerfully vested interests are shared across the border. But a market is a market, and we may be dealing with forces bigger than just the United States Treasury or Fed, but the bigger they are the harder…

Let us add one more to our list. This one is speculative but quite logical. We believe that when it is clear that the US credit cycle is going to contract individuals and investors will deem that the dollar does not qualify as money, provided they are allowed to make the choice, and eventually even if they are not.

Sooner or later the dollar is going to fall from grace as a global international reserve currency, in our view, as a consequence of the illegal devaluation required of a credit currency in a secular bust.

Thus (Robert), I do not think that it will come down to which will be a greater force, deflation or the foreign repatriation of deposits, but what will the primary actor in our economy choose as money when the credit cycle goes indisputably into reverse.

Conclusions
I sincerely hope you understand inflation and deflation better after reading this. At least we do after writing it.

Despite a cogent non-deflationary explanation for many symptoms of deflation today it is likely that the deflation side of the debate will survive. As Mises says, the forces of inflation and deflation are always going to be there.

I wasn't always as convinced as today about the ultimate inflation breakdown. Prior to 1998 and in another life I was in the deflation camp. It was the events subsequent where it became apparent that the nation's obsession with deflation was going to produce what is properly called an inflation breakdown.

An inflation breakdown may manifest in deflation or it may manifest in the money, in which case Keynesians would label it stagflation. It is a breakdown in the inflation agenda responsible for undermining the sound money principle.

The period in between 1971 and 1980 should be properly dubbed an inflation break down, not simply inflation, and especially not the Keynesian term "stagflation." We have had inflation forever. Fact.

Certainly a reversal of the credit cycle may indeed bring about a contraction in the so called money stock, but simultaneously, if the value of the dollar is as we cite largely a function of the viability of the US credit cycle then the consequences ought to show up sooner or later in the exchange value of the dollar against other things that better qualify as money, which perhaps don't have a claim against it, and especially once the credit cycle is deemed a bust.

Deflation? They wish. US Dollar governors (O'Neill and friends) are working hard to make you believe in this economy, and at the moment, in its recovery. Meanwhile the global banking establishment is working hard to defer the consequences of the unprecedented late nineties' malinvestments, particularly the resultant bad loans.

Their efforts, however, largely continue to worsen the underlying problem as well as drag out the corrective forces like Chinese water torture, obviously in the belief that they can re-ignite the full employment doctrine.

Who knows, maybe they can, but it can't last for various reasons we normally cite.

So, when Professor Wanniski says that deflation will result in a declining monetary standard he is plainly wrong. Inflation results in a declining monetary standard when it breaks down.

By saying that deflation is a decline in the monetary standard Wanniski overlooks the savers choice in deciding money by not differentiating between its role as a medium of exchange and its role as store of value. It is no surprise he does this since supply side doctrine assumes that the producer is the primary actor. But at the same time he endorses our argument with respect to the quality of the money, unwittingly.

And we argue that it is quality (defined in his way) indeed that will determine what the individual saver will choose, and in the end, producers have no use for a medium of exchange that isn't accepted by the individual either. Furthermore, simply by offering up a system of money similar to the Bretton Woods agreement, he infers that the money today does not stand on its own. It needs government help.

We would agree that it does not stand on its own, but refuse the government's help in deciding for us where we should keep our savings.

In lieu of this solution alone, we suggest that it must be clear right up to Paul O'Neill's suite that the money is just no good.

If the inflation ultimately leads to a new monetary system, or standard, then we will have deflation.

We cannot have deflation until we have learned to despise inflation.

It will be the change to new money that will create deflation and it will be a good thing in the long run, so long as the money is not a new monetary regime such as the one presented by Professor Jude Wanniski and modeled after Bretton Woods.

Anyhow, all of this cannot end well for the economy indeed, but worse, it cannot end well for the dollar. Money supply can contract while the value of the currency is in decline. It did this August, briefly, while the dollar was in descent. Furthermore, if the objective as well as subjective exchange value of the dollar can rise while it is growing in quantity why on earth could it not decline while it is falling in quantity.

And it shouldn't need to be even said that anyone working for the government or financial sector is unlikely to say the money is bad, for they are in the business of creating it. It follows then if we are correct that since deflation is bullish for the currency, in that it manifests in a rising exchange value against other things, it is vital for policymakers to ensure the deflation argument dominates expectations, which is how they attack inflation expectations.

Promoting the concept of deflation is a policy benefit that we can directly link to the Federal Reserve's interests, and thus deflation arguments even if correct ought to be suspect from an analytical viewpoint. Remember, the idea and agenda is to continue to inflate, but there is no way to do that effectively if inflation expectations rise.

Thus there is deflationary bias in all of their data, which is why when we hear reports that crude inventories are building, they are interpreted as potentially deflationary rather than a reflection of inflation expectations. The year 2001 has been a success for Fed policy in choking off inflation expectations, but it has not and cannot be an instrument of deflation. That is preposterous.

Near the end of his document, Jude Wanniski says, "an obsession with inflation can be counted upon to bring deflation." But so too can an obsession with deflation bring about inflation. Jude Wanniski is not who he appears to be. He is, in our estimation, a reincarnation of John Maynard Keynes; also a generalist with little real economic depth. And his goal is to help Mundell write the new global monetary order perhaps so that the United States does not face an illegal devaluation.

However, so far deflation is just a bogeyman. The rate of growth in money supply continues to astound us, and the only sign of deflation is in some of the shared symptoms that have resulted from a confluence of market and managed events.

If we are wrong and deflation does occur in dollar terms then it is because either the market chooses the dollar as money when the credit cycle implodes, or policymakers rig the dollar through a global monetary system requiring all foreign participants to give up some of their right to full convertibility.

Nonetheless, this may be good for gold prices if gold becomes an anchor in the short term, but it isn't good for capitalism, liberty, or prosperity (excepting the few rigging the game).

Moreover, we don't think it can work because it would require an independent audit of the nation's gold reserves. On the contrary, we are confident that some day the O'Neill Dollar, Greenspan Fed, and the Wanniski Deflation will all become the butt of good ethnic and/or economic humor.

The survival of capitalism depends on it.

1. "Thus the sound money principle has two aspects. It is affirmative in approving the market's choice of a commonly used medium of exchange. It is negative in obscuring the government's propensity to meddle with the currency system." - Mises, on the principle of sound money, pp454, the Theory of Money and Credit

2. The criticism Mises cited by some groups against sound money and liberty at the time was that it was negative in its definition.

3. "The central element in the economic problem of money is the objective exchange value of money, popularly called its purchasing power. This is the necessary starting point of all discussion; for it is only in connection with its objective exchange value that those peculiar properties of money that have differentiated it from commodities are conspicuous. This must not be understood to imply that subjective value is of less importance in the theory of money than elsewhere. The subjective estimates of individuals are the basis of the economic valuation of money just as of that of other goods. And these subjective estimates are ultimately derived, in the case of money as in the case of other economic goods, from the significance attaching to a good or complex of goods as the recognized necessary condition for the existence of a utility, given certain ultimate aims on the part of some individual. Nevertheless, while the utility of other goods depends on certain external facts (the objective use-value of the commodity) and certain internal facts (the hierarchy of human needs), that is, on conditions that do not belong to the category of the economic at all but are partly of a technological and partly of a psychological nature, the subjective value of money is conditioned by its objective exchange value, that is, by a characteristic that falls within the scope of economics." An excerpt from The Theory of Money and Credit; Part Two,, chapter 7 by Ludwig von Mises

4. Jude Wanniski is the president of www.Polyconomics.com, a website dealing with political and economic topics. His career included journalism for the Wall Street Journal, and is known for his book "The Way the World Works," which was the birth of supply side doctrine that some know as Reagan-omics.