The essence of inflation

 

The popular definition cannot explain why inflation is bad

According to the popular way of thinking, inflation is defined as a general increase in the prices of goods and services – described by changes in the consumer price index (CPI) or other price indexes.

 

If inflation is a general rise in measured prices, then why is it regarded as bad news? What kind of damage can it inflict? Mainstream economists maintain that inflation causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources.

 

Despite all of these assertions regarding the side effects of inflation, mainstream economics doesn’t tell us how all of these bad effects are caused. Why should a general rise in prices hurt some groups of people and not others? Why should a general rise in prices weaken real economic growth? Or how does inflation lead to the misallocation of resources? Moreover, if inflation is just a rise in prices, surely it is possible to offset its effects by adjusting everybody’s incomes in the economy in accordance with this general price increase.

 

Why price indices cannot establish the status of inflation

Despite its popularity, the whole idea of a consumer price index (CPI) is flawed. It is based on a view that it is possible to establish an average price 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).

 

Defining what inflation is

We suggest that the reality of inflation is its association with the act of the diversion of real wealth from one individual to another individual by means of an expansion in the money supply.

 

Historically, inflation originated when a country’s ruler such as the king would force his citizens to give him all of their gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,

More characteristically, the mint melted and recoined 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.[1]

Because of the dilution of the gold coins, the ruler could now mint a greater amount of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a gold alloy coin.

 

The increase in the number of coins brought about by this debasement of gold coins is what inflation is all about.

 

If we were to accept that inflation is in effect an increase in the money supply then we are likely to reach the conclusion that inflation results in the diversion of real wealth from wealth generators towards the holders of newly printed (or coined) money. We are also likely to conclude that monetary pumping i.e. inflation is bad news for the wealth generating process.

Note that what we have is an inflation of coins i.e. an expansion in the number of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself).

 

Under the gold standard, the technique of abusing the medium of the exchange became much more advanced through the issuance of paper money unbacked by gold. Inflation therefore became an increase in the amount of receipts for gold – of receipts not backed by gold yet masquerading as the true representatives of money proper, gold.

 

The holder of an unbacked receipt could now engage in an exchange of nothing for something. This produced a situation where the issuers of the unbacked paper receipts diverted real 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 paper money; hence, inflation in this case is an increase in the stock of paper money. (Note that this includes an increase in demand deposits because of the fractional reserve bank lending).

 

An increase in goods supply cannot undo inflation

For most economists, if an increase in the money supply is matched by the increase in the production of goods, then this is fine, since no increase in general prices (as measured by indices) has taken place and therefore no inflation has emerged. We suggest that this way of thinking is erroneous since inflation has very much taken place, i.e., the money supply has increased. This increase cannot be undone by the corresponding increase in the production of goods and services.

 

To continue the king example, once a king has created more gold alloy coins that masquerade as pure gold coins, he is now able to exchange nothing for something irrespective of the rate of growth of the production of goods. Regardless of what the production of goods is doing, the king is now engaging in an exchange of nothing for something, i.e. diverting resources to himself by paying nothing in return.

 

The same logic can be applied to paper money inflation. The exchange of nothing for something that the expansion of money sets in motion cannot be undone by the increase in the production of goods. The increase in money supply — i.e. the increase in inflation — is going to set in motion all of the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the production of goods.

 

Why increase in economic activity does not cause inflation?

For mainstream economists, an increase in economic activity is almost always seen as a trigger for a general rise in prices, which they erroneously label inflation. But 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. This conclusion is not affected even if the so-called economy operates very close to “potential output” (another dubious term used by mainstream economists).

 

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.

 

Milton Friedman and expected inflation

Some economists, such as Milton Friedman, maintain that if inflation is “expected” by producers and consumers, then it produces very little damage (see Friedman’s Dollars and Deficits, Prentice Hall, 1968, pp.47-48).

 

The problem, according to Friedman, is with “unexpected” inflation, which causes a misallocation of resources and weakens the economy. According to Friedman, if a general rise in prices can be stabilized by means of a fixed rate of monetary injections, people will then adjust their conduct accordingly. Consequently, Friedman says, expected general price increases, which he calls expected inflation, will be harmless, with no real effect.

 

Observe that, for Friedman, bad side effects are not caused by increases in the money supply but by the outcome of that – increases in prices. Friedman regards money supply as a tool that can stabilize general rises in prices and thereby promote real economic growth. According to this way of thinking, all that is required is to fix the rate of money supply growth, and the rest will follow suit.

 

It is overlooked here that “fixing the money supply’s rate of growth” does not alter the fact that money supply continues to expand. This, in turn, means that it will continue the diversion of resources from wealth producers to non-wealth producers even if prices of goods remain stable. This policy of attempting to stabilize prices is, instead, likely to generate more instability.

 

Observe that we do not say, as the monetarists postulate, that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

 

Reconciling strong monetary pumping with moderate increases in prices

Given that, for us, inflation is in fact an increase in the money supply, how can we then reconcile strong monetary pumping with moderate increases in prices, conventionally labelled as “low inflation”?

 

The price of a good is the amount of money paid for the good. If the growth rate of money is 5% and the growth rate of the supply of goods 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 the increase in the CPI then one would conclude that, despite this 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 a price index or in output.

 

Prices are determined by both real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. Thus, if money increases by 5% whilst the supply of goods increases also by 5% – no change in prices of goods is going to emerge. Whilst the money supply growth i.e. inflation is buoyant, prices might display no increases.  Now, when the pool of real savings (the total of consumer goods in the economy) is expanding the increase in money supply appears to provide support to both wealth generating and non-productive activities.

 

Once the pool becomes stagnant or starts to decline, increases in the growth rate of money supply can no longer create the illusion that they can set in motion real economic growth. (Note that money is just a medium of exchange and cannot grow an economy, it can only facilitate the transfer of goods from one individual to another individual).

 

Note that the pool of real savings, which supports various economic activities, determines the overall “economic pie” at any point in time. Obviously then, if the pool of real savings is stagnant or declining, the “economic pie” must also follow suit. In this setup, competition among companies to protect their market share is likely to force reductions in the prices of goods and services.

 

In addition, the attempt by various companies to secure profits and stay solvent might force them to lower prices in order to expand the volume of sales. This of course also means that various activities that have emerged on the back of the previous expanding pool of real savings now would have to shrink or disappear altogether.

 

Once a general decline in the prices of goods emerges because of a stagnant or declining pool of real savings, any attempt by the central bank to reverse this general decline in prices will only weaken the pool of real savings further, thereby prolonging the economic hardship.

A better way out of these difficulties is to allow the businesses to get along with the buildup of real wealth whilst at the same time curtailing the central bank’s involvement in the economy through its monetary pumping and lowering of interest rates.  As the buildup of the real wealth gains pace, this enables various activities to emerge again. These emerging activities are likely to be of a wealth generating nature – they are going to be self-supporting and do not require the central bank to engage in monetary pumping and interest rate reduction.

[1] Murray N. Rothbard –  What Has Government Done to Our Money? Libertarian Publishers January 1964 p 32.