Does the Federal Reserve cause inflation?

[BrainGlutton]

This thread on the current presidential candidacy of Ron Paul (onetime Libertarian candidate for POTUS) was getting hijacked into a discussion of the Federal Reserve, inflation, and “hard currency,” so I thought I’d spin that debate off into a separate thread.

1. Does the Federal Reserve system cause inflation in the U.S.?

2. If so, is it the primary cause of inflation? Or even a significant contributing cause?

3. If so, does it matter? That is, is inflation always a bad thing?

4. Could any modern monetary system function efficiently if its money supply were still based on the gold standard?

(“Hard currency” in general was discussed not long ago in this CS thread on Robert Heinlein.)

[BrainGlutton]

5. Is there any good reason to abolish the Fed and/or go back on the gold standard? (Something Ron Paul wants to do, apparently.)

[Common_Tater]

The problem prior to the FED was the “inelasticity” of money or money supply. They called them “panics” prior to “depressions” and they were nasty. There simply can’t be enough specie (as gold or possibly silver was called) to possibly meet the needs of commerce in even just the United States much less the entire world, unless one places a value of a common wedding band at some astronomical figure.

[Rysto]

Good lord. I’ve always said that liberatarians are ignorant of economics despite their loud protestations of love for it, and now we have proof of that.

A certain level of inflation is necessary to keep the economy going. It encourages people to invest their money to recoup the wealth they lose to inflation. Investment is critical for driving long-term economic growth. Also, certain prices, like wages, will almost always be increasing, so it’s important that firms be able to raise their prices to accomodate this.

Any money supply based on the gold standard would essentially be constant. Meanwhile, the demand for money would increase over time(as the population rises). This would lead to a shart deflation, which would be terrible for the economy.

[pantom]

I’m trying to come up with a reasonably complex but still reasonably short post to this thread, but I can’t let this one go.
Please explain, if you can, how the U.S. became the premier economic power in the world by 1913 with a gold standard and a history - except for war - of stable to decreasing prices.

[Measure_for_Measure]

I’ll give it a shot. But please don’t make me read the linked thread.

[QUOTE=BrainGlutton]
This thread on the current presidential candidacy of Ron Paul (onetime Libertarian candidate for POTUS) was getting hijacked into a discussion of the Federal Reserve, inflation, and “hard currency,” so I thought I’d spin that debate off into a separate thread.

1. Does the Federal Reserve system cause inflation in the U.S.?
   [/quote]
   Hm. Milton Friedman said that inflation is always and everywhere a monetary phenomenon. Or something like that.

Put another way, a determined Fed can put a stop to inflationary pressures in an economy, and even reverse them. But doing so might cause a recession.

--------------- 2. If so, is it the primary cause of inflation? Or even a significant contributing cause?

Inflation won’t occur without the acquiescence of the monetary authorities. But consider what happens to an industrial economy in the case of an oil shock. In such circumstances, factory products will cost more to produce. If the Fed wanted to keep the price level constant, lots of prices (and wages) would have to decline to compensate for the higher price of a key input (oil). That’s an option. But if you believe that workers are reluctant to take wage cuts and firms slow to cut prices, then it’s going to take a recession to help the process along.

Alternatively, the central bank could allow a temporary spike in inflation.

The theory of the Phillips curve suggests that policy makers face a short run tradeoff between inflation and unemployment. Friedman believed that this was only over the short-run though, and that over the long run there was a natural equilibrium rate of unemployment.

Fiscal policy (that is, changes in budget deficits or in the Clinton era surpluses) can also stimulate the economy (lowering unemployment and at times raising inflation) or contract it (the opposite).

------------- 3. If so, does it matter? That is, is inflation always a bad thing?

IMO, a little bit of inflation (2-4%, though most central bankers say 1-2%) is a good thing.

------------- 4. Could any modern monetary system function efficiently if its money supply were still based on the gold standard?

Hey, let’s try it out. But what do you mean by efficiently?

Put it another way. Barry Eichengreen has pointed out that price stability was not the rule during the days of the gold standard. Advocates of the gold standard generally use theoretic, not empirical arguments.

[Plan_B]

[QUOTE=Rysto]
Good lord. I’ve always said that liberatarians are ignorant of economics despite their loud protestations of love for it, and now we have proof of that.

A certain level of inflation is necessary to keep the economy going. It encourages people to invest their money to recoup the wealth they lose to inflation. Investment is critical for driving long-term economic growth. Also, certain prices, like wages, will almost always be increasing, so it’s important that firms be able to raise their prices to accomodate this.

[/QUOTE]

I don’t mean this in a bad way, but I’ve honestly never heard that idea before. Do you have any cite to any reputable economist who shares that belief? That’s not a challenge, just a request.

[pantom]

I just remembered that the Chicago Fed’s history of itself has a nice, simple explanation of how the Fed came into being: see Early History.
The controversy centers around this sentence, I believe:

To supply the elastic currency required by the economy, the central bank would re-discount bank notes and issue a new national currency, Federal Reserve notes.

The above is obviously incompatible with a hard-currency system. FRN’s circulated in tandem with US notes, whose issuance was strictly limited by the act that created them in 1862. This set the stage for their abandonment since, as The US Treasury’s page on currencies says:

Both United States Notes and Federal Reserve Notes are parts of our national currency and both are legal tender. They circulate as money in the same way. However, the issuing authority for them comes from different statutes. United States Notes were redeemable in gold until 1933, when the United States abandoned the gold standard. Since then, both currencies have served essentially the same purpose, and have had the same value. Because United States Notes serve no function that is not already adequately served by Federal Reserve Notes, their issuance was discontinued, and none have been placed in to circulation since January 21, 1971.

In short, the FRN, because it was backed by the collateral held in reserve at the banks, which could be either gold/gold securities or the bank notes it received from its member banks, had no statutory limit on how many could be issued - an “elastic” currency whose supply would increase or decrease based on demand (see the FRB’s currency and coin page). Thus, the argument that the Fed is itself the cause of inflation.

[Measure_for_Measure]

[QUOTE=pantom]
I’m trying to come up with a reasonably complex but still reasonably short post to this thread, but I can’t let this one go.
Please explain, if you can, how the U.S. became the premier economic power in the world by 1913 with a gold standard and a history - except for war - of stable to decreasing prices.
[/QUOTE]
Er, wasn’t Great Britain the premier economic power before WWI?

And didn’t the US flirt with the silver standard for a while, thus increasing the level of specie?

And, most critically, is it really appropriate to compare the largely agrarian economy of the 1800s to a modern industrial or post-industrial one today?

[John_Mace]

[QUOTE=Rysto]
Good lord. I’ve always said that liberatarians are ignorant of economics despite their loud protestations of love for it, and now we have proof of that.
[/quote]

Yeah, Milton Friedman was a hack. You might want to narrow down that brush a tad. In fact, you need to narrow it down a lot, especially in light of your comments about economics, below.

A certain level of inflation is necessary to keep the economy going.

Questionable

It encourages people to invest their money to recoup the wealth they lose to inflation. Investment is critical for driving long-term economic growth.

Yeah, no one would invest if there weren’t any inflation.

Also, certain prices, like wages, will almost always be increasing, so it’s important that firms be able to raise their prices to accomodate this.

Generally true of wages, but not true of many prices. In fact, most prices decrease over time, if inflation is low.

Any money supply based on the gold standard would essentially be constant.

So why wasn’t the money supply constant when we were on the gold standard?

I’m not a big fan of the gold standard, but the idea that inflation is caused by the Fed isn’t all that crazy. It’s pretty mainstream thought that The Depression was caused in large part by mismanagement of monetary policy by the Fed.

[pantom]

Measure for Measure, I’ll have to go digging to find the cite, but if I recall correctly by the 1870’s, the US was already the number one industrial producer on the planet. So no, it wasn’t an agrarian economy. Not even close.

[ex747mech]

[QUOTE=Common Tater]
The problem prior to the FED was the “inelasticity” of money or money supply. They called them “panics” prior to “depressions” and they were nasty. There simply can’t be enough specie (as gold or possibly silver was called) to possibly meet the needs of commerce in even just the United States much less the entire world, unless one places a value of a common wedding band at some astronomical figure.
[/QUOTE]

Actually, the panics were caused by the banks creating too many banknotes than what could be redeemed in actual gold. When people realized the paper they held wasn’t backed by gold there was a panic. But the conniving bankers managed to blame the gold for causing panics, not their fraudulent money creation schemes.

You are absolutely correct when you say there isn’t enough gold or silver to meet the needs of commerce. That is a fundmental fact of economics, commodities like money, wool, oranges, lumber, wheat, iron, etc are in short supply. That is what makes them valuable. If there were enough of everything we would be livin on Big Rock Candy Mountain.

The great thing about free markets is people can decide what they think is valuable. Precious metals have worked great as money for centuries, but governments, especially the greedy power-hungry type, don’t like honest money. So they create central banks that give them an unlimited line of credit.

[pantom]

Best I could come up with for now is the Wiki page on historical GDP. If you look at 1870, you see that the US was very close behind the UK. (with India and China ahead of them both. Hmm.) By 1913, it took the output of the entire British Empire to match that of the US all by itself. The UK was already far, far behind.

[Measure_for_Measure]

Thanks for responding pantom.
Here’s some very old Price data for the US:

University of Michigan Library

	US Price	% change	annualized
1815	55		
1820	42	-24%	-5.3%
1825	34	-19%	-4.1%
1830	32	-6%	-1.2%
1835	31	-3%	-0.6%
1840	30	-3%	-0.7%
1845	28	-7%	-1.4%
1850	25	-11%	-2.2%
1855	28	12%	2.3%
1860	27	-4%	-0.7%
1865	46	70%	11.2%
1870	38	-17%	-3.7%
1875	33	-13%	-2.8%
1880	29	-12%	-2.6%
1885	27	-7%	-1.4%
1890	27	0%	0.0%
1895	25	-7%	-1.5%
1900	25	0%	0.0%
1905	27	8%	1.6%

And here’s some employment data:

	Total	Agriculture share
1850	8250	4520	0.55
1860	11110	5880	0.53
1870	12930	6790	0.53
1880	17390	8920	0.51
1890	23320	9960	0.43
1900	29070	11680	0.40
1910	37480	11770	0.31

Your POV comes off fairly well- better than mine, I’d say. I’ll note though that about half the country were farmers from 1850-1880.
Still, I would argue that the vociferous debates regarding the silver and gold standard during the 1800s, and general unhappiness with periodic bank panics (culminating in the establishment of the FDIC in the 1930s), indicates some problems with economic stability during that era.

[pantom]

Yep. The Chicago Fed page I linked to earlier noted that the proximate cause for the Federal Reserve Act was the Panic of 1907. There was a populist movement for silver in the 1880’s and 1890’s, as well. (which led to the “Cross of Gold” speech.)

[DrCube]

[QUOTE=ex747mech]

The great thing about free markets is people can decide what they think is valuable. Precious metals have worked great as money for centuries, but governments, especially the greedy power-hungry type, don’t like honest money. So they create central banks that give them an unlimited line of credit.
[/QUOTE]

Can you elaborate a little? I’m particularly interested in what you mean by gold-backed money being “honest”. I suppose trust money is “dishonest”?
I learned in macroeconomics that the Fed uses monetary policy to keep the economy between extremes of the business cycle. One extreme is a recessionary gap, where potential GDP minus real GDP is a positive number; apparently this is when unemployment is high. The other extreme is an inflationary gap where potential GDP minus real GDP is a negative number; this is when inflation is high. By trying to keep the economy “walking the line” so to speak, the Fed needs there to be a little inflation, so I could see this being construed as “the Fed causes inflation”.

But I don’t really know anything, sorry.

[Measure_for_Measure]

Here’s some GDP info, from Angus Madison (fills in some gaps from Wikipedia).

1870 (billions of 1990$)
US: 98
UK: 100
Germany: 71

1913
US: 517
UK: 225
Germany: 237

The US was indeed the leading industrial power shortly after 1870.

[Measure_for_Measure]

Wikipedia gives the argument for permitting a small amount of inflation:

A small amount of inflation is often viewed as having a positive effect on the economy. One reason for this is that it is difficult to renegotiate some prices, and particularly wages, downwards, so that with generally increasing prices it is easier for relative prices to adjust. Many prices are “sticky downward” and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to deflation, which is generally viewed as a negative outcome because of the significant downward adjustments in wages and output that are associated with it.

http://www.answers.com/inflation

If you believe that workers are not resistant to nominal wage cuts, then you won’t find this argument persuasive.

[John_Mace]

[QUOTE=Measure for Measure]
Your POV comes off fairly well- better than mine, I’d say. I’ll note though that about half the country were farmers from 1850-1880.
[/QUOTE]

I don’t think that was all that unusual. It was probably true of most countries.

[Measure_for_Measure]

[QUOTE=John Mace]
I don’t think that was all that unusual. It was probably true of most countries.
[/QUOTE]
Agreed.

I’m arguing that the economies of the 1870s were rather different than, say, the 1970s, owing to the large share of the labor force that were tied to farming.