In a Properly Functioning Economy Prices Go Up and Down

Poor Ms. Cosgrove. The Florida woman wrecked her car in 1976. While driving under the Brooklyn Bridge a tarp filled with rainwater fell on it. Then, she lost the $17,500 compensation check from the insurance company.

Her luck seemed to change last week - 33 years later. She found the check in a drawer. But now she discovers two disagreeable things at once - that her insurance company has gone out of business...and the check would be worth barely $5,000 - if she were able to cash it.

What follows is a brief reverie on the way credits go bad. There are accidents. There are mistakes. There are acts of God and acts of parliament. To give readers a preview, we suspect that the world's savers and investors are about to follow Ms. Cosgrove - losing money due to bad luck, bad judgment, bad management and bad policy decisions. We leave God to explain His own acts, if He cares to. Our attention is on Ms. Cosgrave's claim check.

Price movements are neither good nor bad; it depends on the cause of them. In a properly functioning economy, prices go up and down. Rising prices suggest scarcity, signaling to consumers that they should switch to substitutes. And they tell producers to get on the ball and stock the shelves with new supply. Falling prices send the opposite message...trimming profit margins and telling producers to cut back.

Here at The Daily Reckoning, when we go into a liquor store and find lower prices, we are delighted. We stock up. But we are clearly out of step with mainstream economists. Most economists want to see higher prices in the liquor store. And they think they can improve the economy by forcing prices upward. Their beef with falling prices is that they trigger what Keynes described as a "propensity to save." Consumers see lower prices, he theorized; they then delay spending in the hopes of a better price. Demand falls, incomes go down. And you have a depression on your hands.

"Unfortunately, most historians and economists are conditioned to believe that steadily and sharply falling prices must result in depression..." writes Murray Rothbard in his History of Money and Banking in the United States. Mr. Rothbard noted that falling prices were neither cause nor effect of depression, but a natural feature of prosperity. In the decade of 1879 to 1889, for example, wages in America rose by 23% - in real terms. "No decade before or since produced such a sustainable rise in real wages," comments Rothbard. In terms of improvements to material well being too, the economist R. W. Goldsmith concluded that no decade matched the 1880s...with 3.8% annual gains.

But this was also a decade when prices fell. Prices at the wholesale level fell 10%. Retail prices dropped 4.2%. How come falling prices didn't cause a depression? In 1884, several big Wall Street banks...including Grant and Ward, the Marine Bank of New York and Penn Bank of Pittsburgh...along with 10,000 businesses across the country...went broke. There was panic on Wall Street. But even this did not cause a depression. The government did nothing. Thanks perhaps to its incapacity, within weeks the economy was back on its feet and the decade of prosperity continued.

This is just the way of the world, when the world is allowed to have its way. In a normal economy, prices are honest. They tell capitalists where and how to invest their money. Businesses increase capacity. They get better at what they do. Unit costs go down. Increased productivity brings higher wages and lower prices - prosperity, in other words.

If that is all there were to it, the world would be more prosperous, but less entertaining. There are honest price movements. And there are the other kind, prompted by changes in the money supply. Natural price movements send useful information; inflation (or deflation)-driven signals are a form of economic counter-intelligence - fraudulent signals intended to mislead. Monetary inflation pushes prices up; but only because money is becoming more abundant, not because goods are becoming more scarce. Businesses, investors and consumers get the wrong idea. Typically, consumers overspend and businesses over-invest. The consumer thinks he sees increasing scarcity. The businessman thinks he sees rising demand. Both are wrong. Both lose money. Even the government is misled by its own flimflam; it sees increasing tax receipts and expands services.

The planet has never seen so much monetary inflation before. In just the last 7 years, worldwide monetary reserve assets have tripled - from less than $2.5 trillion to more than $7.5 trillion. And yet, consumer prices continue to fall...as they have for the last 27 years. In January, despite the Fed's target, The Wall Street Journal reports that "consumer prices [in the US] actually fell by 0.1%...."

Last week, leading economists at the IMF and the Fed wondered aloud they shouldn't deceive the public even further, by setting higher inflation targets. Currently, central banks aim for 2%. Talk is of doubling it to 4%.

Maybe they know what they are doing. Maybe they don't. Advice to readers: if you get a large check, don't wait 33 years to cash it.

Regards,

Bill Bonner
for The Daily Reckoning Australia

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