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December 18, 2007

Deflating the deflation myth

Today’s Downsizer Dispatch . . .

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Quote of the Day:

“Find out just what the people will submit to and you have found out the exact amount of injustice and wrong which will be imposed upon them; and these will continue until they are resisted with either words or blows, or with both. The limits of tyrants are prescribed by the endurance of those whom they oppress.”
– Frederick Douglass

Subject: Deflating the deflation myth

We are amazed. Ron Paul has set records for fundraising. His poll numbers are also good, despite being rigged to hide the true level of his support. He has attracted followers from all corners — conservatives, liberals, libertarians, and centrists. But most of all, we are amazed by the fact that so many people are attracted to . . .

Ron Paul’s position on Honest Money.

We had thought this issue was dead. The subject is abstract and often clouded by academic jargon and obscure technical details. This is one reason why there has been no significant public discussion of it since at least the early 1980s. And yet, we see consistent testimony that Ron’s position on money is one of the main pillars of his popular support.

Another way you can know a position is gaining traction is when people take the trouble to attack it. For instance, the neo-conservative David Frum has written that Ron Paul’s call for a revived gold standard would cause painful economic downturns. Frum maintains that we need the Fed’s monetary inflation to counter such slumps.

Of course, the exact opposite is true. Painful economic downturns are caused by monetary inflation, not cured by it.

I don’t know about you, but I can’t imagine anything more painful than the Great Depression, which was the first inflationary bust caused by the Federal Reserve System. And the inflationary recessions of the 1970s were pretty bad too. Of course . . .

David Frum is really attacking a straw man of his own creation. Ron Paul doesn’t want the old gold standard that was managed by the government. Instead, he simply wants free market money. He wants the free market to determine what we will be use for money, and he naturally assumes that the market would gravitate toward gold, just as it has throughout recorded history.

This would be a free market gold standard, which is very different from the old gold standard under which the government pegged the dollar to gold at $20 an ounce. You can readily see how such a fixed rate of exchange would cause problems.

When the Fed increased the number of dollars under the old gold standard the price of gold should have risen to account for this monetary inflation, but it couldn’t. The price was legally stuck at $20 an ounce. This caused people to want to trade their dollars for gold, creating an economic loss for banks and the government.

I know, it sounds like a stupid system, and it was, but isn’t that exactly how government operates most of the time?

Strangely, Frum praises the system of floating exchange rates between dollars and, for instance, Euros, but pointedly ignores that this is exactly what Ron wants to happen for gold (and other commodities) when they are used as money. Ron Paul doesn’t want a gold standard in the sense of having a standard government price for gold. Ron specifically opposes monopoly government price fixing, such as the old $20 fixed price for gold. That’s the whole point.

Ron wants the price of gold in terms of dollars to rise and fall freely, depending on supply and demand. Thus, if the Fed inflated the supply of FRNs (Federal Reserve Notes, aka dollars) the price of gold would rise and people would fly from dollars to the safety of gold. This would force the Fed to stop inflating the supply of FRNs.

This is the heart of Ron Paul’s simple but powerful plan for curing inflation, and the recessions that result from it.

But Ron’s critics make another point. They claim that using gold for money is inherently deflationary, and that monetary deflation is even worse than monetary inflation. They claim deflation is the true cause of recessions and depressions. Are they right?

We have already shown, in previous messages, how inflation causes recessions and depressions. But does deflation do the same thing, and is gold inherently deflationary? To answer this question we need to be precise in our use of words . . .

If inflation is an expansion of the money supply, it follows that deflation must be a contraction of the money supply. Gold could only be deflationary if a significant part of the world’s gold supply suddenly disappeared. But this just doesn’t happen. Remember . . .

Gold has been used as money throughout history for two very important reasons. 1) It is very hard to find, which severely limits inflation, and 2) It’s durable, which limits deflation. Gold doesn’t just simply disappear, so gold can’t be deflationary in this sense.

What the critics of gold are talking about isn’t monetary deflation, but price deflation — a drop in prices. As an economy grows, and an increased supply of goods and services are offered for sale, prices will fall if the money supply remains static, as would be the case if gold was the dominant form of money. Gold critics claim that falling prices cause recessions and depressions. Are they right?

Consider two examples . . .

Computers have constantly improved in performance, while constantly falling in price. Computers, and consumer electronics in general, have experienced tremendous productivity gains and severe price deflation. Are the computer and consumer electronics industries in recession as a result? Of course not. They form the backbone of our economy.

Lasik eye surgery has also constantly improved in quality and fallen in price. Are Lasik eye surgeons experiencing recession as a result? Of course not. Instead, this one free market corner of the highly government controlled health care industry is a part of our health care economy that is really thriving.

The reason for this is simple. Productivity gains pay for themselves, allowing producers to charge less.

Using gold for money allows the benefits of increased productivity to be widely shared by everyone, through the mechanism of steadily falling prices. This is a benefit of a stable money supply, not a flaw.

The exact opposite is true of an inflationary money supply, where the benefits are enjoyed by those who get the new money first, and the price for their gain is paid by everyone else.

The gold critics are right that a stable money supply enables prices to fall, but they are wrong that this causes recessions. Instead, it makes everyone wealthier, not just the political elites that have privileged access to the Fed’s stream of inflated funny money.

If you’re ready to gain the benefits of honest money, by repealing the Fed’s legal tender monopoly, then please ask Congress to pass Ron Paul’s “Honest Money Act.”

Thank you for being a part of the growing Downsize DC Army.

Jim Babka & Perry Willis
President & Communications Director, Inc.

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