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This article will briefly expand upon the introduction of Austrian monetary inflation and deflation as introduced in "What is a Dollar Bill Worth?". There we learned the Rothbard definition of modern-day monetary inflation as any increase in the economy's supply of fiat paper money. This is the current best definition of Austrian monetary inflation in the modern world of floating fiat currencies. Austrian monetary deflation would likewise be the decrease in an economy's supply of money. 

[Rothbard at far right, Burt Blumert at far left.  Mr. Blumert, founding publisher of lewrockwell.com and a champion of monetary freedom, died last week.  Here is a tribute to Mr. Blumert from Lew Rockwell (2nd from left.) photo courtesy mises.org]

However, Austrian monetary X-flation is NOT the only effect on the price levels of goods and services. If it were, the mathematical example given in Part 2 would be observed in reality - if one could magically double the money supply overnight, the price levels of all goods and services would double very quickly thereafter.

Classical economics teaches the principle of supply and demand. If demand were to increase suddenly, if the supply side could not react, the price level would increase to compensate for the lack of availability of desired goods. If supply costs rise with theoretically constant demand, the producer will lose profit unless the price level is increased. Also, Ludwig von Mises famously wrote about the general theory of human action, or praxeology, and its economic effects. People - regardless of their stations and roles in society and life - all make economic decisions based upon the satisfaction of their desires, regardless of how this desire came to existence.

[Aside - Of course, 'good' deflation can also be caused by growth deflation - such as increased efficiency in the manufacture of goods - think the price of a certain computer model over time. Deflation can also be caused by saver's deflation. When money is saved at higher rates (and all other factors are theoretically assumed constant), this will increase the demand for money, or increase its purchasing power relative to goods or services, resulting in a drop in price.]

Much of the consternation in the "global financial crisis" of today consists of Keynesians like FED Chairman Ben Bernanke and the ex-FED Secretary of Treasury Timothy Geithner who are (publicly) focused on solving issues using the monetary weapons most familiar to them, which we learned about in How the Fed Works. However, even many Austrian commentators, most famously Peter Schiff, tend to overstress the monetary economic aspects and fail to stress the field of credit economics enough.  Although Schiff makes perfect economics sense from the standpoint of monetary economics, does his analyses hold up from the standpoint of credit economics?  [This will be discussed in the next article.] (photo from ephix, license)

The Latin root of credit is "credere," which means "to believe" or "to have faith in." Credit is a form of quasi-money. Anyone who owns a credit card, realizes they can instantly turn their "credit line" into cash and or use it directly to purchase goods, although there is always a promise to pay, usually with interest, in the future. The degree to which an individuals (most infamously financial corporations) is utilizing borrowed money is referred to as leverage.

As we learned in "How the Fed Works", a traditional fractional reserve bank would be expected to have an assets:loan ratio leverage of roughly 9; for every $1 of "assets" such as your deposits, the bank may $9 of loans that it plans to collect interest on. Modern banks, however, have far higher leverage by using not just loans but financial derivatives, which will be explained in Part 10-11. Citibank, for instance, has a nominal derivative amount:assets leverage ratio of 25. Goldman Sachs, a former investment bank turned bank holding company, has a derivatives:assets leverage of an eye-popping 186 per the December 2008 data from the Treasury's OCC office (see page 22/33).

Periods of time where credit is expanding will tend to create price inflation, or what I will term "Austrian credetary inflation." Likewise, a credit contraction can lead to price deflation, or "Austrian credetary deflation." Although this type of X-flation applies to all forms of credit, let's see if I can give an example using bank credit.

The Smith family decides to take a loan from a bank and purchase a house, a long-use consumer good, on their credit. The bank "has faith" that the Smiths can pay back the loan plus interest in the future. Now, if there are enough families who have credit extended to them, they will compete for other houses, or goods, and as a result the sellers will tend to increase the price.

Likewise, if the credit of all buyers is suddenly reduced or eliminated, sellers will tend to decrease the price as there is less competition for the same good.

Any prices sought in the present or future are not only to some extent based on the future anticipation of the willingness of others to buy, but also based on total available credit. In other words, there IS a difference between 300 million people with credit of $100,000 per person as compared to the same population with a credit of only $1,000 per person. Likewise, just because sufficient credit is available is not enough by itself to cause "credetary inflation"; people or companies must have already acted and used this credit, or are expected to act towards utilizing this credit in the future. In other words, it does little good to give someone a credit card for $100,000 with, say, a 10% interest rate, if that someone decides, for whatever reason, to not use the card at all.

Credit is neither good nor evil. Some economists point out that credit is not even necessary, but most would agree that credit has enabled many individuals and companies to grow much faster than they otherwise could have. However, not many would challenge the claim that credit has also ruined the lives of many, even though modern society has (somewhat) moved away from debtor's prisons. To a medieval European peasant family, a mortgage did not carry the same penalties as to the Smiths, who worst case would file for bankruptcy. "Mort" came from morte or mortal, and a "gage" was a pledge. A modern definition for this archaic term is literally "a deal with death."  Think about THAT next time you pay your bank or landlord!

In periods of time where credit expands at high rates, the booms tend to cycle towards busts such as the subprime bust, the Dow plunge from 14,000, and the not-yet-arrived options/ARM/ALT-A bust. Credit expansion-contraction cycles can also significantly debase currencies, such as the Icelandic krona.  Furthermore, this credetary inflation, along with true Austrian monetary inflation of the money supply, combined to produce price inflation of property, goods, services, and assets. However, what occurs when credit contracts, causing credetary deflation, while monetary inflation continues? Better yet, what happens when we lose track of the value of these paper credit instruments that are in fact forms of quasi-money?

Well, it's an important question as we are all living through this time period right now. When the monetary value of credit vastly exceeds the monetary value of property and the money supply, historically the result has been "panics," depressions, or even revolutions.  Let's pause first to review "What the Heck Are Derivatives?", then shift back as I will try to answer the last two questions above in my next installment.