Part 1 | Part 2 | Part 3 | Part 4 | Part 5 | Part 6 | Part 7 | Part 8 | Part 9 | Part 10 | Part 11 | Part 12 | Part 13 | Part 14 | Part 15 | Part 16 | Part 17 | Part 18 | Part 19 | Part 20 | Part 21 | Part 22 | Part 23 | Part 24 | Part 25 | Part 26 | Part 27 | Part 28 | Part 29 | Part 30 | Part 31 | Part 32 | Part 33 | Part 34 | Part 35 | Part 36 | Part 37 | Part 38 | Part 39 | Part 40 | Table of Contents
One indication of rising standards of living in a society is increases in the quantity and quality of goods available to the consuming public. For example, during the 20-year period from 1880 to the turn of the century, there occurred a dramatic increase in the productive capacity of the U.S. economy, matched by an equally significant expansion of goods and services. In their Monetary History of the United States, 1867-1960 (1963), Milton Friedman and Anna Schwartz pointed out:
“The two final decades of the nineteenth century saw a growth of population of over 2 per cent per year, rapid extension of the railway network, essential completion of continental settlement, and an extraordinary increase both in the acreage of land in farms and output of farm products. . . . At the same time, manufacturing industries were growing even more rapidly.”
As a result, between 1879 and 1897, real net national product increased at an average annual rate of about 3.7%, with per capita net national product increasing at a 1.5% annual average rate during this period. The improvements in productive capacity and output, of course, did not occur evenly year by year. During this period, the United States experienced several severe economic downturns, sometimes related to the uncertainties surrounding the political battles of the time concerning whether America would remain on a gold standard or shift to a bi-metallic standard of gold and silver.
But what is also interesting about this period of rapid industrial growth and rising standards of living in American history is that it occurred during a time when prices in general were falling. Between 1865 and 1899, the average level of prices declined more than 45%. From 1880 to 1897, prices in general declined by more than 22%, or 2%-3% each year.
“Economic growth,” as Milton Friedman later observed, “was entirely consistent with falling prices.” Assuming that there is neither an increase in the supply of money nor a decrease in the demand for money, it is inevitable that increases in productivity and output and, therefore, the quantities of goods and services offered on the market will result in the prices of those goods and services decreasing. Given the demand for any commodity, an increase in its supply will result in a decrease in its price if every good that is offered for sale is to attract enough buyers to take it off the market.
If improvements in productivity and increases in output are occurring in many sectors of the economy more or less at the same time, then many prices will be decreasing, each one sufficiently so to bring supply and demand into balance in its respective market. If statistical averages of market prices are calculated before and after these increased supplies of goods have been placed on the market, they will show that there has occurred a decline in the general “price level” of goods and services. The market will have experienced a “price deflation.”
But it should be clear that there is nothing inherently harmful in this type of deflationary process. If an entrepreneur introduces a technological innovation to lower his costs of production, it is because he hopes to be able to make a commodity for less, so he can offer it for a lower price and still reap larger profits. The price decline is part of his plans. Even if it is competition over time from his market rivals that causes him to fully lower his price to his now-lower costs of production, there are no negative consequences for the economy. Competition will have done its job — to compete prices down to the lowest level consistent with the most efficient costs of manufacturing.
It is, of course, possible that an entrepreneur might overestimate the larger quantity that will be demanded at the lower price. As a consequence, his total revenue will be less than before he introduced cost efficiencies into his operation. This means that consumers value other goods on the market more than his particular product. For example, suppose his old price was $10 and he had been selling 100 units of his commodity each month. His monthly total revenue would have been $1,000. Suppose the new price is $9 and he sells 105 units per month; his total revenue would now be $945. Consumers would be buying more of his good but economizing $55 while doing so.
The consumers would shift their saved dollars towards increased purchases of other things that previously they could not afford to buy. Suppose that an entrepreneur in another market has also introduced cost efficiencies into his line of production. Previously, he sold 200 units of his commodity each month at a price of $16 a piece, for a total revenue of $3,200. Now he prices the good at $15 and sells 217 units each month, for total revenues of $3,255. Consumers will be buying more of this second good, as well, and paying for the additional quantities bought with the $55 saved on the first good. Previously consumers spent a total of $4,200 on the two goods and obtained 100 units of the first good and 200 units of the second. After cost efficiencies in production have lowered prices, they still spend a total of $4,200 on the two goods, but now they are able to buy 105 units of the first good and 217 units of the second. Their standard of living has improved through an increase in the real buying power of the dollars in their possession.
In the jargon of the economist, the demand for the first good was inelastic (at the lower price, total revenue was less than before), while the demand for the second good was elastic (at the lower price, total revenue was more than before). As a result, it may be necessary for some of the resources, including labor, to be let go in the manufacture of the first good and be reemployed in the market where the second good is produced. There is simply no way to get around this in the long run. Changes in demand or supply always carry with them the need to modify what goods are produced, where they are manufactured, and with what combinations of resources they are to be produced. It is part of the price people pay in a free society for improvements in the quantities and qualities of the goods and services offered on the free market.
If there is an attempt to prevent prices from adjusting to their market-clearing levels in the face of cost efficiencies and greater supply, the result can only be imbalances and distortions in the market. Eventually the adjustments must conform to the reality of supply and demand. Delaying or retarding them only builds up a backlog of needed market changes that will be more severe and sharper in their effects than if the necessary incremental adjustments had been allowed to occur as they slowly manifested themselves through time.
In the late 1920s and early 1930s, Austrian economist Friedrich A. Hayek argued that the policy of price-level stabilization was creating such imbalances in the market by preventing a fall in prices in the face of cost efficiencies and greater supplies of goods offered in the market. He made this case in an essay, “Intertemporal Price Equilibrium and Movements in the Value of Money” (1928), and in two books, Monetary Theory and the Trade Cycle (1929) and Prices and Production (1931) .
Hayek said that if a proper balance between supplies and demands was to be maintained through time, then the price of each good had to reflect the actual supply and demand conditions in existence in the various markets during each time period. Any attempt to “stabilize” the price of a good or a set of goods at some given “level” across time, in spite of differing market conditions that might arise as time passed, would set in motion market responses that would be “destabilizing.”
If, for example, the supply of a good was going to be greater in the future than today because of the introduction of some productive innovation that would lower costs, and if equilibrium was existing in that future period as well as in the present period, then the price of that good in the future period (assuming given demand conditions) would have to be lower than the price in the present period. If the good’s future price was to be “stabilized” across time at the “level” that prevailed in the present, the future expected profit margins would be greater than if natural market forces had been at work competing the price down to reflect the new, lower costs of production. The “stabilized” higher price in the future period would tend to induce an excess production of the good in comparison to what the “real” supply and demand conditions would dictate, and this “surplus” would eventually create a destabilizing effect in this market.
What was true for any particular good would be true for a situation in which there is a general expansion of output due to falling costs across many markets. If each price in this situation is permitted to find its proper equilibrium level, then as measured by some statistical averaging, the general “price level” would decline. But the structure of relative prices would keep the various supplies and demands in balance across time.
However, through most of the 1920s, the Federal Reserve expanded the money supply in an attempt to prevent prices from falling in the face of increasing supplies of goods resulting from cost efficiencies in the methods of production. The monetary expansion created a situation in which the prices for various goods and services in the market were above what they would have been but for the increase in the money supply.
Suppose, using our previous example, that both of our two entrepreneurs had lowered their costs by $1 per unit, enabling them to lower their prices from $10 and $16 to $9 and $15 respectively. But now suppose that the government monetary authority increases the money supply by $322 and distributes this sum among consumers in a manner that enables them to buy 5 more units of the first good and 17 more units of the second good at the original prices of $10 and $16 respectively. The first entrepreneur will now earn total revenues of $1,050 instead of $945, and the second entrepreneur will earn total revenues of $3,472 instead of $3,255. Our two entrepreneurs would be earning, respectively, additional profits of $105 and $217, with total spending on the two goods being $4,522 instead of $4,200.
The artificially maintained selling prices and the larger earned profits would now stimulate these entrepreneurs to try to expand their respective outputs to, say, 110 and 225 units. But for consumers to be able to buy these larger quantities at the original prices of $10 and $16, total consumer spending would have to be $4,700 ($1,100 for the first good and $3,600 on the second good). If the money supply was not expanded another $178 by the time the additional quantities of goods were offered on the market, the entrepreneurs would discover that they had increased their supplies on the market in excess of the consumers’ ability to buy them at the original prices of $10 and $16.
Furthermore, in the process of attempting to expand their outputs because of the stimulus of greater profits, the entrepreneurs would have to attract resources and labor away from other sectors of the economy if they were to increase their levels of production. Part of the additional profits earned, therefore, would have to be expended as higher resource prices and wages to bid them away from their alternative employments in other parts of the economy.
But unless there were to be a change in the patterns of consumer demand, when the resource owners and workers earned the higher input prices and wages, they would spend them not on buying the larger quantities of the two goods that were now available on the market, but rather on other goods they preferred to buy. As result, it would be discovered that too many of the two goods were being supplied on the market and too few of other commodities.
The market would then have to go through a “correction” in which output was cut back in the two sectors of the economy that had originally experienced the cost efficiencies, and resources and labor would have to be reallocated back to other sectors of the economy where consumer demand was greater. The false appearance of economic stability with a stabilized “price level” would be hiding the fact that the monetary expansion that stabilized the price level was in fact distorting profit margins and creating imbalances in the relative supplies of various goods offered on the market.
The Austrian economists then combined their theory of money with their theory of capital and interest to develop what became known as the Austrian theory of the business cycle.