An Imagined Panacea for Economic Ills

The John Law school of economics remains alive and well. A recent article in the NYT informs us that In Fed and Out, Many Now Think Inflation Helps” [sic].

A few excerpts:


“Inflation is widely reviled as a kind of tax on modern life, but as Federal Reserve policy makers prepare to meet this week, there is growing concern inside and outside the Fed that inflation is not rising fast enough.

Some economists say more inflation is just what the American economy needs to escape from a half-decade of sluggish growth and high unemployment.

The Fed has worked for decades to suppress inflation, but economists, including Janet Yellen, President Obama’s nominee to lead the Fed starting next year, have long argued that a little inflation is particularly valuable when the economy is weak. Rising prices help companies increase profits; rising wages help borrowers repay debts. Inflation also encourages people and businesses to borrow money and spend it more quickly.

The school board in Anchorage, Alaska, for example, is counting on inflation to keep a lid on teachers’ wages. Retailers including Costco and Walmart are hoping for higher inflation to increase profits. The federal government expects inflation to ease the burden of its debts. Yet by one measure, inflation rose at an annual pace of 1.2 percent in August, just above the lowest pace on record.

“Weighed against the political, social and economic risks of continued slow growth after a once-in-a-century financial crisis, a sustained burst of moderate inflation is not something to worry about,” Kenneth S. Rogoff, a Harvard economist, wrote recently. “It should be embraced.”


We have previously commented on Mr. Rogoff's inflationist quackery. The idea that inflation 'helps' the economy is based on the erroneous notion that it is spending that drives economic growth. This is not only a theoretical error, it is also disproved by historical experience. For instance, the historical period in which US real economic growth reached its zenith were the decades prior to the institution of the Federal Reserve, which were attended by mildly falling prices (mildly falling prices are a natural feature of a progressing economy).

Of course the assertion that the Fed “has worked for decades to suppress inflation” is utterly ridiculous in light of the fact that the dollar's purchasing power was more or less stable in the century before the Fed was founded and has declined by more than 96% in the century thereafter. The central bank is not 'suppressing' inflation, it is the very engine of inflation.

Inflation properly defined is an increase in the supply of money. This does not always have to be accompanied or immediately followed by a widespread fall in  money's purchasing power, but it certainly alters relative prices in the economy, as newly created money enters the economy at discrete points. The effect is always pernicious: it redistributes wealth from late to early receivers of newly created money and it leads to capital malinvestment and the associated boom-bust cycle.

This is not to say that inflation doesn't have superficial attractions – there are good reasons why so many people are in favor of it. In the short term, it  may appear to be beneficial, as it creates illusory accounting profits and can increase 'economic activity'.

If it is true that Costco and Walmart are hoping for inflation to increase their profits, then they are pinning their hopes on an illusion. A part of the profits businesses make during periods of inflation are imaginary – the result of falsified economic calculation. In reality, businesses are consuming part of their  capital without even noticing it.

For an excellent analysis of how inflation ruins businesses as a result of capital consumption due to the falsification of economic calculation we refer you to Fritz Machlup's excellent study on capital consumption in Austria (pdf) in the interwar years, which we have occasionally mentioned in the past. After the first World War, a number of countries experienced very high inflation (the most famous case is of course the total currency collapse of the Weimar Republic), thereby providing us with excellent case studies that confirm what economic theory has to say on the topic.

Since so many are arguing that 'more inflation is needed', we cannot resist to once again post Michael Pollaro's chart of the broad US money supply TMS-2 below. One should not lose sight of the fact that monetary inflation has been quite extreme in recent years, even by the standards of the pure fiat money regime.




US money supply TMS-2 (components by legal categorization) since 1960 – by Michael Pollaro, click to enlarge.



Leaving aside the fact that 'price indexes' attempt to measure something that is inherently unmeasurable (i.e., the 'general price level'), it may be conceded that consumer prices are not rising very fast at the moment. However, some prices in the economy are definitely rising; similar to what could be observed several times over the past two decades or so, the bulk of the price increases seems concentrated in asset prices. Most economists as well as the monetary authorities appear not to believe these price increases to be harmful, and yet, we have seen the bursting of two asset bubbles in the past 13 years and the fallout of the last one continues to weigh on the economy to this day. It seems therefore odd that asset price bubbles continue to be ignored in this context.


Popular Fallacies vs. the Market Solution

The fallacy of relying on price indexes to 'measure' inflation (i.e., to measure one of its possible effects) and adapt the pace of monetary pumping accordingly has led to large economic booms and busts many times since it has been adopted. The busts are then lengthened and deepened by trying to fight the after-effects of the collapsed boom with the same methods that have led to the problem in the first place. And yet, if one looks at articles in the mainstream press such as the one in the NYT that has prompted us to write this post, the discussion is solely focused on the effect inflation may or may not have on consumer price indexes. Even the critics of inflationary policies seem to concentrate exclusively on this side issue. And of course those who promote inflation as a cure for the economy's ills such as Mr. Rogoff, accuse the Fed of being 'too meek', which is utterly bizarre in view of zero interest rates and $85 billion of additional money creation every month. One wonders what exactly Mr. Rogoff wants the Fed to do? Buy up everything that isn't nailed down with money from thin air?


“Critics, including Professor Rogoff, say the Fed is being much too meek. He says that inflation should be pushed as high as 6 percent a year for a few years, a rate not seen since the early 1980s. And he compared the Fed’s caution to not swinging hard enough at a golf ball in a sand trap. “You need to hit it more firmly to get it up onto the grass,” he said. “As long as you’re in the sand trap, tapping it around is not enough.”

All this talk has prompted dismay among economists who see little benefit in inflation, and who warn that the Fed could lose control of prices as the economy recovers. As inflation accelerates, economists agree that any benefits can be quickly outstripped by the disruptive consequences of people rushing to spend money as soon as possible. Rising inflation also punishes people living on fixed incomes, and it discourages lending and long-term investments, imposing an enduring restraint on economic growth even if the inflation subsides.

“The spectacle of American central bankers trying to press the inflation rate higher in the aftermath of the 2008 crisis is virtually without precedent,” Alan Greenspan, the former Fed chairman, wrote in a new book, “The Map and the Territory.” He said the effort could end in double-digit inflation.

The current generation of policy makers came of age in the 1970s, when a higher tolerance for inflation did not deliver the promised benefits. Instead, Western economies fell into “stagflation” — rising prices, little growth.

Lately, however, the 1970s have seemed a less relevant cautionary tale than the fate of Japan, where prices have been in general decline since the late 1990s. Kariya, a popular instant dinner of curry in a pouch that cost 120 yen in 2000, can now be found for 68 yen, according to the blog Yen for Living.

This enduring deflation, which policy makers are now trying to end, kept the economy in retreat as people hesitated to make purchases, because prices were falling, or to borrow money, because the cost of repayment was rising.

“Low inflation is not good for the economy because very low inflation increases the risks of deflation, which can cause an economy to stagnate,” the Fed’s chairman, Ben S. Bernanke, a student of Japan’s deflation, said in July. “The evidence is that falling and low inflation can be very bad for an economy.”


(emphasis added)

There are certainly a number of problems ailing Japan's post bubble economy. Lower prices for popular instant dinners are definitely not among them. It is this one sentence that immediately makes clear how little sense all this belly-aching about 'deflation' (in the sense of falling consumer prices) really makes. Are not consumers much better off when they have to pay less rather than more for goods and services? 

When assessing Japan's economy, its biggest problems are too much government spending and a raft of stifling regulations, but certainly not falling consumer prices. The idea that Japan is 'worse off' because the domestic purchasing power of the yen has slightly increased is absurd. As anyone who has visited Japan can attest to, there is absolutely no reason to suspect that Japan is anything but a rich country. It has an enviably low unemployment rate and is the world's biggest creditor. The fact that credit expansion ex nihilo has slowed down in Japan is not a bad thing, it is a good thing (of course the BoJ is currently busy implementing an inflationary policy as well).

It is simply untrue that falling prices lead to 'economic stagnation'. We would be very curious to hear Mr. Bernanke explain the fact that the US economy never grew faster in real terms than in the 'deflationary' decades prior to the founding of the institution he heads. He probably can't explain it –  his studies of economic history don't seem to go back further than 1929, so there is no reason for him to attempt to reconcile this evidence with his theoretical views.

No matter what the inflationists assert, it is not possible to create wealth by printing more money – the exact opposite is true. As Murray Rothbard pointed out, if one thinks the position of money in the economy properly through, it becomes clear that society at large cannot gain anything if its supply is increased – in this respect, money is different from every other good and service that is produced.

We are sure that if one were to ask Mr. Rogoff or Mr. Bernanke how it comes that places like Zimbabwe, Venezuela or Argentina are not the richest countries in the world, they would argue that they 'inflated too much'. But what exactly is 'too much'? How can they possibly know? How can Mr. Rogoff be certain that we need an annual decline in the exchange value of money of 6%? Why not 4% or 7%? And how does he propose to measure it, given that it is not possible to gauge the price effects of inflation independently of the supply of and demand for money?

If there were a free market for money, unexpected sudden increases in the demand for money (due to exogenous events like e.g. the threat of war) would likely also see a reaction from the supply side.  However, the increase in resources devoted to obtaining a larger supply of the money commodity (in a free market, money would be a commodity with a pre-existing use value) would be strictly guided by the wishes of consumers. Moreover, even if the money supply were completely fixed, a demand for higher cash balances would simply lead to adjustment by raising money's purchasing power until the higher demand was satisfied (we are assuming that if a free market in money were to obtain, the entire economy would likely be unhampered; prices and wages would be free to adjust).

Given the enduring popularity of inflationary policies, we suspect that lessons that should have been learned long ago will have to be relearned – the hard way.





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3 Responses to “A Collective Pining for More Inflation”

  • worldend666:

    One inflation tax that rarely gets talked about is capital gains tax. Inflation causes not only constant price rises but also booms and busts.

    Be sure if you sell an asset in the boom you will be taxed full whack, but if you sell it in the bust nobody will allow you to offset your losses against your income tax.

  • No6:

    These crooks do know better.
    All this inflation talk is to dupe the public. Remember they have been told over the last generation that central banks are necessary to protect the currency and keep inflation low.
    The cartel will do whatever it takes to stay in business, including a ‘little more inflation’. (which is just another form of bank bailout.)

  • AustrianJim:

    Like the Bourbons, the Fed has forgotten nothing, and learned nothing.

    “…when a theory seems right, when a glib and intelligent spokesman explains why the theory will work this time, we find it difficult to resist giving it another and yet another try. So many people seem to find fault, not with the theory, but with the circumstances of its use, as though it was circumstances that failed the theory, not the other way around.”

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