By Dr Frank Shostak
For most commentators the role of central authorities is to make the economy as stable as possible. What do they mean by economic stability? Economic stability refers to an absence of excessive fluctuations. An economy with constant output growth and low and stable price inflation is likely to be regarded as stable.
An economy with frequent boom-bust cycles and variable price inflation would be considered unstable. According to popular thinking, a stable economic environment in terms of stable price inflation and stable output growth acts as a buffer against various shocks. This makes it much easier for businesses to plan. In this way of thinking in particular, price level stability is the key for economic stability.
For instance, a relative strengthening in people’s demand for potatoes versus tomatoes may take place. This relative strengthening is going to be depicted by the relative increase in the prices of potatoes versus tomatoes. Now to be successful businesses must pay attention to consumers’ wishes as manifested by changes in the relative prices of goods and services.
Failing to abide by consumers’ wishes will lead to the wrong production mix of goods and services and will lead to losses. Hence, in our case, by paying attention to relative changes in prices businesses are likely to increase the production of potatoes versus tomatoes. On this way of thinking if the price level is not stable then the visibility of the relative price changes becomes blurred and consequently, businesses cannot ascertain the relative changes in the demand for goods and services and make correct production decisions.
This leads to a misallocation of resources and to the weakening of economic fundamentals. Unstable changes in the price level obscure changes in the relative prices of goods and services.
Consequently, businesses will find it difficult to recognize a change in relative prices when the price level is unstable. Based on this way of thinking it is not surprising that the mandate of the central bank is to pursue policies that will bring price stability i.e. a stable price level.
By means of various quantitative methods, the Fed’s economists have established that at present policy makers must aim at keeping price inflation at 2%. Any significant deviation from this figure constitutes deviation from the growth path of price stability. Observe that Fed policy makers are telling us that they have to stabilize the price level in order to allow the efficient functioning of the market economy.
Obviously, this is a contradiction in terms since any attempt to manipulate the so-called price level implies interference with markets and hence leads to false signals as conveyed by changes in relative prices. By means of setting targets to interest rates and by means of monetary pumping it is not possible to strengthen economic fundamentals, but on the contrary, it only makes things much worse. Here is why.
Policy of price stability leads to more instability
Let us say that the so-called price level is starting to exhibit a decline in terms of its growth momentum. To prevent this decline the Fed starts to aggressively push money into the banking system. Because of this policy after a time lag, the price level has stabilized. Should we regard this as a successful monetary policy action?
Given that monetary pumping sets in motion the diversion of wealth from wealth generating activities to non-wealth generating activities obviously this leads to the weakening of the wealth generation process and to economic impoverishment. Note that the economic impoverishment has taken place despite price level stability. Also, note that in order to achieve price stability the Fed had to allow an increase in the growth momentum of the money supply. The fluctuations in the growth momentum of money supply matter here. It is this, that set in motion the menace of the boom bust cycle regardless of whether the price level is stable or not.
While increases in money supply are likely to be revealed in general price increases, this need not always be the case. Prices are determined by 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. While money growth is buoyant prices might display moderate increases. Clearly, if we were to pay attention to the so-called price level and disregard increases in the money supply, we would reach misleading conclusions regarding the state of the economy.
On this, Rothbard wrote,
“The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware” (America’s Great Depression, Mises Institute, 2001 , p. 153).
Money neutrality assumption is at the root of price stabilization policies
At the root of price stabilization policies is a view that money is neutral. Changes in money only have an effect on the price level while having no effect whatsoever on the real economy. In this way of thinking changes in money supply, do not have any effect on the relative prices of goods and services. For instance, if one apple exchanges for two potatoes then the price of an apple is two potatoes, or the price of one potato is half an apple.
Now, if one apple exchanges for one dollar then it follows that the price of a potato is $0.5. Note that the introduction of money does not alter the fact that the relative price of potatoes versus apples is 2:1 (two-to-one). Thus, a seller of an apple will get one dollar for it, which in turn will enable him to purchase two potatoes.
In this way of thinking, an increase in the quantity of money leads to a proportionate fall in its purchasing power i.e. a proportionate rise in the price level. While a fall in the quantity of money results in a proportionate increase in the purchasing power of money i.e. a proportionate decline in the price level. All that does not alter the fact that one apple is exchanged for two potatoes, all other things being equal.
Let us assume that the amount of money has doubled and as a result, the purchasing power of money has halved, or the price level has doubled. This means that now one apple can be exchanged for $2 while one potato for $1. Note that despite the doubling in prices a seller of an apple with the obtained $2 can still purchase two potatoes. We have here a total separation between changes in the relative prices of goods (how many apples exchanged per potatoes) and the changes in the price level.
Therefore, it would appear that the only problem with inflation is that it obscures the visibility in the movements of the relative prices of goods thereby causing a misallocation of resources. Other than that, inflation is harmless. Why this way of thinking is problematic?
Following the Cantillon effect when new money is injected there are always first recipients of the newly injected money who benefit from this injection. The first recipients with more money at their disposal can now acquire a greater amount of goods while the prices of these goods are still unchanged. As money, starts to move around the prices of goods begin to rise.
Consequently, the late receivers benefit to a lesser extent from monetary injections or may even find that most prices have risen so much that they can now afford fewer goods. Increases in money supply lead to a redistribution of wealth from later recipients, or non-recipients of money to the earlier recipients.
We suggest that this shift in wealth likely to alter individuals’ demands for goods and services and in turn alter the relative prices of goods and services. Changes in money supply sets in motion new dynamics that give rise to changes in demands for goods and to changes in their relative prices. Hence, changes in money supply cannot be neutral as far as relative prices of goods are concerned.
Price level cannot be ascertained conceptually
We suggest that it is not possible to establish the total purchasing power of money and hence the price level. When one dollar is exchanged for one loaf of bread, we can say that the purchasing power of one dollar is one loaf of bread. If one dollar is exchanged for two tomatoes then this also means that the purchasing power of one dollar is two tomatoes. The information regarding the specific purchasing power of money does not however allow the establishment of the total purchasing power of money. It is not possible to ascertain the total purchasing power of money because we cannot add up two tomatoes to the one loaf of bread. We can only establish the purchasing power of money with respect to a particular good in a transaction at a given point in time and at a given place.
On this Rothbard wrote,
Since the general exchange-value, or PPM (purchasing power of money), of money cannot be quantitatively defined and isolated in any historical situation, and its changes cannot be defined or measured, it is obvious that it cannot be kept stable. If we do not know what something is, we cannot very well act to keep it constant.
Now, the Fed’s monetary policy that aims at stabilizing the price level by implication affects the growth rate of money supply. Since changes in money supply are not neutral, this means that a central bank policy amounts to the tampering with relative prices, which leads to the disruption of the efficient allocation of resources.
As a result, a policy of stabilizing prices leads to the over-production of some goods and the under-production of some other goods. This is, however, not what the stabilizers are telling us. For they believe that the greatest merit of stabilizing changes in the price level is that it allows free and transparent fluctuations in the relative prices, which in turn leads to the efficient allocation of scarce resources.
Economic stability has nothing to do with stabilizing the economy
We hold that what matters for economic prosperity is not price stability but rather allowing free relative price fluctuations. Only in an environment free of government and central bank tampering with the economy free fluctuations in relative prices can take place. This in turn is going to allow businesses to abide by the wishes of consumers i.e. will permit an efficient allocation of scarce resources.
We suggest that in the absence of central authorities tampering with markets fluctuations in prices are going to mirror changes in the relative supply-demand conditions. Note that the Soviet Union after 1947 established a stable price framework based on fixed prices. Whilst this prevented price inflation, it however set persistent shortages of food and consumer goods. By not allowing the free movement of prices this resulted in a drastic decline in individuals living standards.
Summary and conclusion
For most economists, the key to healthy economic fundamentals is price stability. A stable price level, it is held, leads to the efficient use of the economy’s scarce resources and hence results in better economic fundamentals. It is not surprising that the mandate of the Federal Reserve is to pursue policies that will generate price stability.
We suggest that by means of monetary policies that aim at stabilizing the price level the Fed actually undermines the workings of the market economy. In this sense, the former Soviet Union hardly had inflation in terms of prices of goods because the price mechanism was kept stable by government decree. The side effect of this were persistent shortages and very low living standards of individuals.
It would appear that an ever-growing interference of the government and the central bank with the working of markets moves the US economy towards the growth path of persistent economic impoverishment and drastically low living standards as time goes by.