Why we need perpetual inflation

[Fried_Egg]

I’m involved in a discussion elsewhere in which my antagonist asserted that the money supply needs to grow in order to support/enable economic growth. Without a growing money supply, the economy cannot grow.

Of course, I retorted by saying that as long as prices can adjust downwards, there’s no reason in theory why any particular sized economy cannot function. But he insists that it will just get stuck in a deflationary spiral until new money is created.

It’s no use using the historical example of the period of the classic gold standard (1830-1914) because the money supply did increase over this time (albiet at a much slower pace). Although there were periods of deflation, overall, there was around zero price inflation from the beginning to end of this period (for both the UK and US). My antagonist suggested that the amont of growth in this period was effective limited by how quickly they could mine new gold.

Now, I countered this by saying that the mining of new gold was infact driven by econommic growth. As the purchasing power of money increased, the demand for gold would increase making it more protitable to mine gold. But this is really just arguing which came first, the chicken or the egg. Did new money enable growth or did growth drive the increase in new money?

In trying to pin down my antagonist on why we need perpetual inflation in our economy, he had this to say:

It is a structural fault not with fractional reserve banking but with lending at interest that a stagnant supply of money will eventually no longer be able to meet the ever increasing demand for money created by interest on loans. Fractional reserve banking can increase the supply of money through lending but that does not in itself create enough money to pay the interest on loans. For that to happen new wealth must be found and converted to new money. Even without fractional reserve banking this would happen. Without an ever increasing money supply debtor defaults are inevitable because there is never enough money in circulation to pay all debts.

I’m not quite sure how best to address the above argument. It doesn’t quite add up to me but I can’t quite articulate why. Can anyone help?

[yuberries]

BY THE POWER OF GOOGLE

I HAVE THE MURPHY

http://mises.org/daily/4569

short answer: conflating money stock w\ money flow.

just because at one point in time, there may not be enough money for everyone to repay their loans, doesn’t mean that it can’t be done in the future, w\o the need of new money. it just depends on how money flows

And, I believe, in a free-money system, w\ more 100% reserve deposits than not, the chances of a large bank run would be much reduced to the point of impossibility

[Fried_Egg]

Thanks for that link yuberries, I shall have a read now.

Although it has also occurred to me that my antagonist’s claim that the economy needs an expanding money supply in order to grow is quite different from the argument that the economy needs an expanding money supply in order to avoid perpetual debt defaulting.

[djsherin]

The 1870’s saw overall price deflation yet very high real GDP growth. Industrial production dipped in the middle of the decade with the recession of 1873, but still ended the decade well above where it started. The 1880’s were very strong years for real wages and I believe the trend in prices was deflationary. You have to break the 19th century up into smaller periods to really analyze it.

That the price level was similar in 1800 and 1900 was more chance than anything in my opinion. The money supply was only nominally limited by the amount of gold. The price level skyrocketed during times like the civil war (a doubling in 4 years) when the government simply printed money to pay for its operations. I remember hearing a lecture by Robert LeFevre that stated that the government only backed its issuance of dollars by 1/4 of that amount in gold. So for every 4 dollars, there would only have been 1 dollar of gold in reserves. The amount of reserves as well as paper issued would have likely fluctuated at various times (so the ratio wouldn’t always be 1/4) but the point is the country was never really on a true gold standard.

There were also periods of bank credit expansion and subsequent contraction all throughout the century due to fractional reserve banking (supported at different times by central banking, suspensions of specie payment, and nationalized banking).

When your friend starts talking about interest payments not being able to be made, I think he’s going off the deep end. Sure the banking sector takes in interest as well as principal; any business that makes a profit takes in more money than it pays out. It’s not as if the banks simply collect interest and suck all the money out of the economy. The money gets paid out in salaries, dividends, rent, maintenance, etc. just like with any other business.