By Dr Frank Shostak
The recent large increases in the growth rate of the US consumer price index (CPI) has fueled concerns that if the rising trend were to continue the Fed is likely to tighten its interest rate stance. Observe that the yearly growth rate in the CPI climbed to 5% in May from 4.2% in April and 0.1% in May 2020.
Most commentators including top US government officials have dismissed the increases in the CPI as transitory. They expect the growth rate in prices to weaken during 2022. According to US Treasury Secretary Janet Yellen, she does not expect that inflation will be a problem for the U.S. economy and that any price increases would be transitory because of supply chain shortages and the rebound in oil prices to pre-pandemic levels.
For other commentators particularly those that follow in the footsteps of the monetarists school of thinking, inflation is likely to accelerate sharply because of massive increases in money supply. Note that the yearly growth rate of our measure of money supply (AMS) climbed to 79% in February from 6.5% in February 2020.
According to monetarists, various increases in the prices of goods and services that are currently taking place are the manifestation of increases in money supply.
Note that both camps are regarding inflation as persistent increases in the prices of goods and services. We suggest that this definition of what inflation is all about is problematic. Here is why.
Definition of inflation
The subject matter of inflation is embezzlement. Historically, inflation originated when a country’s ruler such as king would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process of minting new coins, the king would lower the amount of gold contained in each coin and return lighter gold coins to citizens.
Because of the reduced weight of gold coins that were returned to citizens, the ruler was able to generate extra coins that were employed to pay for his expenses. What was passing as a gold coin of a fixed weight was in fact a lighter gold coin. On this Rothbard wrote,
More characteristically, the mint melted and re – coined all the coins of the realm, giving the subjects back the same number of “pounds” or “marks”, but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.
Note that what we have here is an inflation of coins i.e. an increase in the quantity of coins brought about by the ruler making the gold coins lighter. The extra gold coins that the ruler was able to generate enabled him the channeling of goods from citizens to himself.
The process of embezzlement was further enhanced when for safety reasons instead of holding gold with themselves, individuals were storing their gold possession with their banks. To acknowledge this storage the banks were issuing receipts. Over time, these receipts had become accepted as the medium of exchange. Problem however would occur once the banks started to issue receipts that are not backed up by gold. The un-backed by gold receipts were now employed in the economy along with the fully backed by gold receipts. What we have here is the inflation of receipts because of the introduction of un-backed by gold receipts. (Note that an un-backed by gold receipt is masquerading as the true representative of money proper, gold).
The issuer of un-backed receipts could now engage in an exchange of nothing for something. This produced a situation where the issuers of the un-backed receipts diverted goods to themselves without making any contribution to the production of those goods.
In the modern world, money proper is no longer gold but rather coin and notes in circulation hence; inflation in this case is an increase in the supply of this type of money. The increase in the supply of money sets an exchange of nothing for something. This amounts to the diversion of real wealth from wealth generators to the holders of newly increased money. Also, note that in the modern world banks are issuing demand deposits that are partially backed by money. This is labelled as fractional reserve banking.
It follows then that the essence of inflation is not a general rise in prices as such but an increase in the supply of money. Note that we do not say as monetarists are suggesting that inflation is caused by increases in money supply. What we are saying is that inflation is increases in money supply. These increases as a rule manifest through increases in the prices of goods and services. On this Mises wrote,
To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying “catch the thief”. The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.
Money and prices
We find it extraordinary that in attempting to explain movements in prices; various commentators have nothing to say about the role of money in forming the price of a good. After all a price of something is the amount of money, i.e. dollars paid per unit of something. (The number of dollars per one loaf of bread, or the number of dollars per one shirt etc.).
Once money enters a particular market, this means that more money is paid for a product in that market. Alternatively, we can say that the price of a good in this market has gone up. Note again that a price is the number of dollars per unit of something.
Observe that when money is injected it enters a particular market. Once the price of a good is rising to the level that is perceived as fully valued then the money leaves to another market, which is considered as undervalued.
The shift of money from one market to another market is not instantaneous there is a time lag from increases in money and its effect on the average price increases.
We suggest that because of recent massive increases in the money supply, it is likely that the growth momentum of prices is going to follow a rising trend in the months ahead. Note again that the yearly growth rate of our measure of money supply the AMS climbed to 79% in February this year from 6.5% in February 2020.
Is it possible to establish the average price of goods?
Despite its popularity, the whole idea of a consumer price index (CPI) is questionable. It is based on a view that it is possible to establish an average of prices of goods and services.
Suppose two transactions are conducted. In the first transaction, one loaf of bread is exchanged for $2. In the second transaction, one liter of milk is exchanged for $1. The price, or the rate of exchange, in the first transaction is $2/one loaf of bread. The price in the second transaction is $1/one liter of milk. In order to calculate the average price, we must add these two ratios and divide them by two; however, it is conceptually meaningless to add $2/one loaf of bread to $1/one liter of milk.
On this Rothbard wrote, “Thus, any concept of average price level involves adding or multiplying quantities of completely different units of goods, such as butter, hats, sugar, etc., and is therefore meaningless and illegitimate. Even pounds of sugar and pounds of butter cannot be added together, because they are two different goods and their valuation is completely different” (Man, Economy, and State, p. 734).
Why strengthening in economic activity does not cause general increase in prices.
By popular thinking, an increase in economic activity is almost always seen as a trigger for a general rise in prices, which is erroneously labelled inflation. However, why should an increase in the production of goods lead to a general increase in prices? If the money stock stays intact, then we will have here a situation of less money per unit of a good — a fall in prices.
Only if the pace of money expansion surpasses the pace of increase in the production of goods will we have a general increase in prices. Note that this increase is only on account of the inflation of money and not on account of the increase in the production of goods.
Another popular explanation for a general rise in prices is the increase in wages once the economy is close to the potential output.
If the amount of money remains unchanged then it is not possible to raise all the prices of goods and wages. So again, the trigger for a general rise in prices has to be monetary expansion.
Reconciling strong monetary pumping with moderate increases in prices
Following the definition that inflation is increases in the money supply, how can we then reconcile strong monetary pumping with moderate increases in prices, conventionally labelled as “low inflation”?
Now if the growth rate of money is 5% and the growth rate of goods supply is 1% then prices will increase by 4%. If, however, the growth rate in goods supply is also 5% then no increase in prices is going to take place, all other things being equal.
If one were to hold that inflation is increases in prices then one would conclude that, despite increase in money supply by 5%, inflation is 0%. However, if we were to follow the definition that inflation is about increases in the money supply, then we would conclude that inflation is 5%, regardless of any movement in the price index.
Again, if money increases by 5% whilst the supply of goods increases also by 5% – no change in the prices of goods is going to emerge. While the money supply growth, i.e. inflation, is buoyant, prices are not going to increase, all other things being equal.
What is the present status of inflation?
So what is the present status of inflation? Again, by popular thinking, as depicted by the yearly growth rate in the consumer price index (CPI), inflation stood at 5% in May against 4.2% in April and 0.1% in May 2020.
However, in terms of money supply the growth rate of inflation stood at 79% in February against 6.5% in February 2020. We suggest that given the massive increase in monetary inflation there is a growing likelihood that the yearly growth rate of the consumer price index (CPI) is poised for a strong increase ahead. We also suggest that what matters is not increases in the CPI as such but increases in money supply. Increases in money supply set the process of impoverishment of wealth generators and set the boom-bust cycle menace.
Note that increases in the prices of goods and services are just the symptoms of the increases in money supply. These increases in prices do not cause the diversion of real wealth from wealth generators to the holders of money out of “thin air”. Price increases are indicators as it were that tell us that the embezzlement of wealth producers is taking place. (Note that price increases do not always portray the severity of the damage inflicted upon wealth producers).
Once money is injected, it starts the process of impoverishment of wealth producers. Because of the time lag between changes in money supply and the act of embezzlement, the impoverishment cannot be arrested as such. To prevent the further impoverishment of wealth generators what is required is the closure of all the loopholes for the increases in money supply.
Despite recent large increases in the consumer price index (CPI), most commentators are of the view that these increases will be transitory. They are of the view that the growth rate of the CPI is likely to weaken visibly in 2022. We suggest that what matters here, is increases in money supply, which is what inflation is all about. Given the recent massive increases in the yearly growth rate of money supply, we can conclude that as time goes by the manifestation of this is likely to be exhibited through the increases in the general prices of goods and services. Regardless of how the symptoms of inflation are going to be displayed, what matters as far as economic health is concerned is increases in money supply, which set in motion the impoverishment of wealth generators.