Archive for March 12th, 2012

Price stability does not always lead to monetary stability, nor to financial stability

Price stability has been adopted as the best policy goal in our days by most central banks. It is indeed a step forward in light of the inflationary dicretionary policies adopted in previous decades. However, as some Austrian theorist masterly exposed in the 20s and 30s of the 20th century (of course, Hayek did), it is not only a panacea not a sound policy goal in the face of a growing economy. This is because there are “benign deflations” associated with increases in productivity and the expansion of markets that need not be counter-balanced by the central bank. In few words, a benign deflation is compatible with a stable nominal income path and thus with monetary stability. In its place, the current anti-inflationist central banks’ policies are designed to offset any deflationary trend, even mild deflation, whatsoever its origin and nature. Thus, within these policy rules, money supply must grow to offset the declining pattern of prices. In my view, this has been at the core of the excessive money creation problem during the last business expansion; and a key reason that explains the monetary and financial chaos created thereafter.

Prof. Pedro Schwartz (CEU University, Madrid) and myself have studied this question in the last years and here goes the link to the presentation I made on it last January in a roundtable at the École Normale Supérieure (Paris) (http://www.anr-damin.net/spip.php?article31). We studied how the price level remain truly stable from 1868 to 1914 in Spain; when the Bank of Spain did not have to target inflation and led prices evolve according to changes in the supply and demand in the markets. Suprinsingly enough, current price stabilising central banks have not achieved that degree of true price stability.

Juan Castañeda


The work that serves as the background of my presentation (“Spain’s deflations and monetary stability in the late 19th c.”) will be published in MONETA collection in May 2012. Here you can find the abstract and conclusions of prof. Pedro Schwartz’ s and myself piece.


We study and identify a different type of deflation that affected the Spanish economy from the launch of the peseta in 1868 to the start of World War I. In the 20th century price deflations have been interpreted as monetary phenomena leading to recession and financial instability. However, this is just one type of deflation. Real price falls can originate from productivity gains. They can be the effect of a growing supply of goods and services in an expanding economy. This was the case in the UK and the US during the second half of 19th century and Spain was not an exception. Gold standard central banks did not watch the price level but were constrained by the guarantee of convertibility into gold. Though Spain was on a silver standard and silver depreciated with respect to gold, the Spanish price level remained remarkably stable from 1868 to 1914. Around this trend, mild real deflations were allowed to take place and balanced modest inflations. Productivity-based deflations could take place in the monetary environment of the late mid 19th century. Central banks did not at that time suffer from an inflationary bias. They did not feel they had to offset deflation at all costs by increasing the means of payment in circulation. In our day, central banks react to avoid every fall in the price level or fall in the rate of inflation, even if it is the result of growing output. In the late 19th century prices could change more freely to reflect gains or losses in productivity. This flexibility contributed to Spanish price stability in the late 


We have focused our attention on those benign or productivity-induced deflations, as they have been widely neglected in post WW II literature, which has had important policy implications in the way monetary policy has been conducted. This type of deflation is to be allowed in a market economy with flexible and open and competitive markets. Rather than an exception, they are the welcome result of real growth. These benign deflations can be observed in the late 19th century, when price stability was an indirect and long term result of the convertibility but not a goal to be pursued directly by central banks.  Their strategic goal was to keep the connection of their currency with the gold or silver anchor. Such was the case of Spain, where the silver standard resulted in half a century of stable prices, though the Bank did not even measure them continuously. Paradoxically, today’s central banks are made to pursue of price stability directly but in the long term have presided over a secular loss of purchasing power of their fiat moneys. In our days, inflation targets are the norm but continuous price inflation is the reality. Modern central banks fear all types of deflation but by ignoring the beneficial effects of productivity led deflations they are led to a secular over-expansion of the money supply.



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