For the 12 months that ended in July 2018, price inflation in the United States, as measured by the Consumer Price Index, was 2.9 percent. That is, a basket of goods that cost $100 in July 2017 increased in expense by almost $3 by July 2018. But is this sort of index really all that needs to be emphasized when discussing the impact of inflationary processes at work in the United States or any other country in the world? No, very far from it.
The Consumer Price Index has long been a headline-grabbing indicator of inflationary pressures in the U.S. economy. It is the number that is often highlighted in the media every month, and one that policy analysts and news pundits often ponder and prognosticate about concerning where the overall economy may be heading.
Economy-wide pricing pressures, they worry, may be suggesting unsustainable growth and employment levels — that is, output and job creation too far above the long-run trend line of potential gross domestic product. Or a “too low” overall price inflation, they fear, may be suggesting a drag preventing the economy from reaching or maintaining its growth potential.
The Federal Reserve’s 2 Percent Price-Inflation Policy
A formal and informal consensus has emerged among many of the world’s leading central bankers that a desirable rate of general price inflation is 2 percent a year. Why? First, they believe that a moderate rise in prices creates an economic environment of optimism and profitability. Second, 2 percent price inflation gives those central banks, it is said, some wiggle room to manipulate the money supply and interest rates compared to a more constraining range of price inflation closer to, say, a zero annual rate if the economy needs monetary and fiscal stimulus.
On the first rationale, the Swedish economist Knut Wicksell (1851–1926) explained the fundamental fallacy in the idea that rising prices can give a permanent lift to economic activity, especially if the rate of increase in the general level of prices comes to be anticipated by market actors. Said Wicksell in his book Interest and Prices (1898):
If a gradual rise in prices, in accordance with an approximately known schedule, could be reckoned on with certainty, it would be taken into account in all current business contracts, with the result that its supposed beneficial influence would necessarily be reduced to a minimum.
Those people who prefer a continually upward moving to a stationary price level forcibly remind one of those who purposely keep their watches a little bit fast so as to be more certain of catching their trains. But to achieve their purpose they must not be conscious or remain conscious of the fact that their watches are fast; otherwise they become accustomed to take that extra few minutes into account and so after all, in spite of their artfulness, arrive too late.
As for the second rationale, it, of course, presumes it is both desirable and possible for governments and their central banks to successfully manipulate the money supply and interest rates to establish and sustain economy-wide stability and growth. The history of the last 100 years, including in the United States, raises serious doubts concerning both the wisdom and ability of those appointed as the monetary central planners to perform this task. (See my e-book Monetary Central Planning and the State.)
A crucial reason why monetary and fiscal planners fail in their endeavors to direct the market economies over which they assert their authority is that the very categories and indicators they use as the signposts for what they may need to do are themselves false signals hiding from view the reality of the complex market system.
The Informational Limits of Gross Domestic Production
By near necessity, the monetary and fiscal central planners need measurements of the economy as a whole to do their directing of the market. This means they rely on a variety of aggregates and averages upon which to set their sights. GDP, for instance, is a summing up of all private sector final consumption and investment activity, along with total government spending, during a given period of, say, a quarter or a year.
Lost in translation, among other things, are the microeconomic patterns of relative demands, relative supplies, relative supply chains of production through different periods and stages of production, and the structure of relative prices that interconnects and links all of these complex and interdependent activities, one with the other.
It is true that the GDP numbers, as compiled and made public by the government’s Bureau of Economic Analysis, break down the totals into micro-categories of specific types of consumption and consumption goods, and different types of investments and investment goods.
But this tells nothing about whether the resulting consumption demands and investments were or were not in patterned coordination with each other. For instance, since for accounting purposes all business-held additions to inventories of output are considered as “planned purchases” of their own output that they have not sold at current prices to consumers or business buyers, there is no way of knowing with any certainty whether some or all of these additions to inventory at the end of a given period represented planned decisions or, instead, production errors that have left enterprises with greater amounts of their respective outputs than they had planned for and desired.
The latter would represent imbalances and discoordination. Likewise, there is no way of knowing whether this was also an indication of disequilibrium pricing of various goods due to incorrect expectations both of what buyers were interested in purchasing and the prices at which they might have been willing to demand relative amounts of the consumption or investment output produced by the multitude of individual private enterprises.
What the Consumer Price Index Hides From View
That which is hidden beneath the aggregates is also unseen in the Consumer Price Index. The Bureau of Labor Statistics, which issues the CPI data every month, also breaks down the aggregate number, which represents an averaging of all surveyed prices in the economy, into fairly detailed subcategories of consumer goods and services purchased by income earners and other spenders in the United States.
Thus, while the overall average of the increase in consumer prices was 2.9 percent, energy prices over that 12-month period rose by over 25 percent (and fuel oil went up even more, by almost 35 percent). On the other hand, piped gas services decreased by 1.3 percent. Food prices, in general, went up by 1.4 percent, but food purchased for cooking at home increased by a low 0.4 percent while eating out at restaurants over the year that ended in July 2018 rose by 2.8 percent.
Apparel prices in general only rose by 0.3 percent, but transportation prices went up by 4 percent and, under the latter category, auto insurance increased by 7.4 percent. Residential housing costs increased by 3.6 percent, but hospital services rose by 4.6 percent.
In other words, the prices of these and many other goods listed in the CPI were all over the place. What conclusion should we draw about any particular consumer’s or household’s cost of living based on the change in these prices during that 12-month period? Not very much.
The CPI is constructed on the basis of a presumed average American family in an urban area, in terms of the basket of goods that family buys and the relative amounts in it. But who is average? Over the year that ended in July, tobacco products experienced a general increase in prices of 3.1 percent and alcoholic beverages of 1.5 percent. But what if you don’t smoke or drink? What if you are a regular drinker of some types of alcohol, but you don’t smoke? On the other hand, what if you don’t drink, but you are a pack-a-day smoker?
Suppose business-related travel required you to drive long distances several or even many times during the month. As we saw, automobile gasoline prices went up by more than 25 percent. But what if your business travel was mostly long distance by air? Airline fares during those 12 months actually decreased on average by 4.1 percent, according to the CPI.
How prices are impacting people depends upon their particular basket of goods, which may vary widely from others in society. There is also the fact that prices are not necessarily changing in the same direction or by the same percentage, as we saw, which means the structure of relative prices is changing; in turn, this means the types of goods and the relative amounts of them that individuals, households, or subgroups of consumers purchase are all subject to change, as people attempt to modify their purchases to economize on what they are buying to still get the most they can of desired items, given their respective incomes. Thus, the composition of the basket rarely stays the same over any period of time, which undermines the use of the CPI aggregate basket as any common denominator to truthfully give an indication of what is going on in terms of the cost of living and “price level” in the economy as a whole.
Long ago, the Austrian economist Gottfried Haberler argued:
The general price level is not a given, a self-evident fact, but a theoretical abstraction. An economically relevant definition of a price level cannot be independent of the purpose in mind, and for each purpose a separate index number must be computed.…
Each class [group of people], and strictly speaking, each person, spends his income in a different way and consumes different goods.… It follows that in strictness, a separate price index ought to be computed for each individual or, at least, for each homogeneous group of persons.
What is the value, or purchasing power, of the monetary unit? It is the array of all the individual price ratios among a unit of money and all the other individual goods against which that money potentially trades. The reason index numbers were originally constructed was to try to summarize that complexity by creating a hypothetical consumer or household to derive a composite indication and measurement of what was happening to prices in general and any accompanying changes in the cost of living.
But the very construction of such a representative consumer or household ends up assuming away all the detailed realities and nuances of the buying patterns of the individuals in the society that reflect the actual circumstances of the market. (See my article “The Consumer Price Index, a False Indicator of Individual Costs-of-Living.”)
A reply might be: but nonetheless, the statistical aggregates such as the CPI can still serve as a policy tool for the monetary central planners concerned with maintaining or improving the macroeconomic stability and growth of the economy as a whole.
The Illusion of Economic Stability With a Stable Price Level
It can easily fail this policy purpose as well. One example of this is Federal Reserve monetary policy in the 1920s. Following the post–World War I boom and recession, the Fed managers decided one of their policy goals was to maintain a relatively stable price level — that is, to avoid either general price inflation or general price deflation. Price-level stability was considered an indicator of economy-wide stability and prosperity. In fact, between 1922 and 1928, the Federal Reserve kept the general wholesale price index within a fairly narrow range, with the price level of 1922 an implicit benchmark.
The 1920s, often touted as the “return to normalcy” following the postwar boom and bust, was one of significant technological improvement, numerous cost-efficiencies in many sectors of the economy, and the marketing of a wide variety of new and improved goods and services. Here was a growing economy experiencing notable productivity increases, full employment, and no inflationary (or deflationary) forces suggesting any underlying instabilities.
Indeed, John Maynard Keynes in his A Treatise on Money, which appeared in 1930 and was written before the Great Depression, said: “The successful management of the dollar by the Federal Reserve Board from 1923 to 1928 was a triumph … for the view that currency management is feasible.”
This is what made the shock of the stock market crash in October 1929 and the accelerating decline in output and employment between 1930 and 1933 so unnerving for so many. Between 1929 and 1933, gross national product decreased by 54 percent; investment spending went down by 80 percent; and consumer spending was off by 40 percent. Unemployment rose from 3.2 percent in 1929 to over 25 percent in early 1933.
Wholesale prices went down by 23 percent, with farm prices decreasing by 52 percent between 1929 and 1933. Over 9,000 banks failed, and the overall money supply in the economy contracted by about 30 percent during this period.
The Austrian Theory of the Business Cycle
How could this have all come about? A theoretical answer to this question was given 90 years ago, in September 1928, by a young Austrian economist named Friedrich A. Hayek (1899–1992), at a meeting of the Verein für Sozialpolitik (Association for Social Policy) made up primarily of economists, historians, and sociologists in the German-speaking world. Hayek’s presentation became the core chapters of the book he published in 1929, Monetary Theory and the Trade Cycle.
Hayek built upon the monetary and business cycle theory developed several years earlier by his intellectual mentor, Ludwig von Mises (1881–1973), in the latter’s The Theory of Money and Credit (1912) and Monetary Stabilization and Cyclical Policy (1928). Mises had argued that the business cycle was not something inherent in the workings of a competitive market economy. Its cause could be found in monetary mismanagement by central banks through interest rate manipulation that resulted in a market rate of interest below a competitively established “natural rate” — that is, the rate of interest that would bring about balanced coordination between savings and investment in the economy.
By increasing the money and credit supply through the banking system, and thereby tending to push interest rates below that natural rate, central bank policy set in motion an inflationary boom that not only brought about rising prices, but induced amounts and types of investments that later would be found unsustainable, given the actual supply of savings set aside out of income by households. (See my article “Monetary Fallacies and Inflationary Bubbles.”)
But the 1920s, especially in the United States, was not experiencing any price inflation. The Federal Reserve, as explained above, was using the monetary policy tools at its disposal to, in fact, prevent any inflation or deflation that would have been an indicator of economy-wide problems.
Hayek pointed out that inflationary bubbles could be set in motion even if there was no absolute rise in the general level of prices. Hayek argued that in an economy experiencing significant increases in productivity and related cost-efficiencies, the resulting increases in output at lower per-unit costs of production would normally bring about falling prices in the economy.
With increased supplies of goods at lower costs, taking consumer demands for those goods as given, to clear the market — that is, for all that is being offered to find willing buyers — the prices of each of these goods tends to be competitively bid down and sold at those lower prices. A fall in prices due to cost-efficiencies and greater output implies none of the negative connotations frequently identified with a general price deflation. It produces a rising standard of living as each consumer’s given amount of dollars now buys more, better, or new goods at lower prices. (See free-banking economist George Selgin’s monograph Less Than Zero on this form of a “good deflation.”)
In fact, Hayek emphasized that for stable and properly coordinated supplies of and demands for goods across time, a fall in these prices is essential. Any attempt to maintain prices at some initial level in the face of increased supplies is analogous to a price control that sets a floor below which the prices of the affected goods cannot be bid down. A price floor generates a longer-run unsustainable mismatching of greater supplies of these goods and the amounts consumers are willing to take off the market at those artificial prices. Wasteful and market-distorting surpluses of such goods are the consequence, requiring some future adjustments to rebalance these markets.
A Stable Price Level Can Destabilize an Economy
The gist of Hayek’s argument on how price-level stabilization brings about economic-wide destabilization was summarized in Monetary Theory and the Trade Cycle:
The rate of interest which equilibrates the supply of real savings and the demand for capital cannot be the rate of interest which also prevents changes in the price level. In this case, stability of the price-level presupposes changes in the volume of money: but these changes must always lead to a discrepancy between the amount of real savings and the volume of investment.
The rate of interest at which, in an expanding economy, the amount of new money entering circulation is just sufficient to keep the price-level stable, is always lower than the rate which would keep the amount of available loan-capital equal to the amount simultaneously saved by the public: and thus, despite the stability of the price-level, it makes possible a development leading away from the equilibrium position.
To prevent prices in general from falling in the manner described due to decreasing costs and increased output, an increased quantity of money must be introduced into the economy. But institutionally the way increases in the money supply are injected into the market is through the banking system, by the central banking authority increasing the quantity of loanable funds at the disposal of the banks.
This is what Hayek argued the Federal Reserve had been doing in the mid-1920s. In the graph below, we see that between 1922 and 1928, the price level as measured by the wholesale price index had been kept in a relatively narrow band. But Hayek’s point was that if not for this activist Fed, policy prices would have gently fallen over the decade as outputs were increasing and costs of production were declining.
Instead, the Federal Reserve expanded the money supply, and by increasing the amount of money available with which greater money demand could be expressed in the market, prices in general were kept higher than they would have been if not for central bank intervention. Thus, in spite of a relatively stable price level, the American economy was experiencing a “relative inflation.” That is, the price level was kept above what it otherwise would have been as measured by such a price index.
To attract additional borrowers to take up this increased supply of loanable funds, the banks lowered the rates of interest at which they were ready and willing to extend loans. But now the quantity of investments undertaken was in excess of the actual amount of savings income earners had chosen to set aside while the time structure of the periods of production initiated with the additional lent funds was longer than otherwise. Thus, the patterns of investment were now out of balance with the savings out of income to sustain them — that is, the real resources available for investment projects instead of more consumer-goods-oriented production activities. (See my article “Interest Rates Need to Tell the Truth.”)
When in early 1929 the Federal Reserve stopped expanding the supply of money and credit in the way it had been and interest rates began to rise, the stock market, investment, and housing market began to decline.
The severity and depth of the Great Depression should not distract from an appreciation of Hayek’s analysis of the causes behind the artificial and unsustainable boom preceding 1929. Beneath the aggregate price level, Federal Reserve policy had distorted interest rates and imbalanced savings and investment — and through this, the structure of relative prices of consumption goods and production goods — and brought about misallocations of capital, labor, and other resources.
Microeconomic imbalances and distortions below the surface of a stable macro price level and seemingly sustainable growth set the stage for the economic downturn of the 1930s. Did the resulting depression have to be as deep and prolonged as it turned out to be? Austrian economists like Mises and Hayek argued that there was no reason that it had to, if not for misguided monetary, fiscal, and interventionist policies by first the Herbert Hoover administration and then the New Deal agenda of Franklin D. Roosevelt. (See my articles “The Great Depression and the Crisis of Government Intervention” and “The New Deal and Its Critics.”)
Mises’s and Hayek’s analyses, though originally penned nine decades ago, still have as much relevance today as in that earlier epoch. This is especially true with their emphasis on the micro monetary processes at work in a market economy that lie beneath the analytically limiting and usually superficial macro aggregates and averages. Thus Hayek’s Monetary Theory and the Trade Cycle remains a relevant source of economic understanding 90 years after its publication.