Why economic growth causes price decline not increase? 

By Dr Frank Shostak

Some economic commentators are of the view that whenever the economy strengthens it should be the role of the Federal Reserve (Fed) to step in at some stage and introduce a tighter interest rate stance in order to prevent general increases in the prices of goods getting out of control. However, why should economic growth be positively associated with general increase in the prices of goods and services?  We suggest that economic growth is about an increase in the production of goods and services that individuals require to support their life and wellbeing. 

Now, the price of a good is the amount of money paid per unit of this good. It follows that for a given amount of money, all other things being equal, an increase in the amount of goods and services, results in a decline and not in an increase in the prices of goods and services. (We now have more goods and services for an unchanged amount of money).  

Hence, one should expect an inverse correlation between changes in the prices of goods and services and changes in the production of goods and services all other things being equal. 

Why should more wealth, which raises people’s living standards, also cause a general increase in the prices of goods and services? Note that in a free market the rising purchasing power of money, i.e. declining prices, is the mechanism that makes a great variety of goods produced accessible to many people.  

On this Murray Rothbard wrote,  

Improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of free enterprise to all the public, raising the standard of living of all consumers.  

Why economic growth cannot be quantified 

Real economic growth cannot be ascertained as such since it is not possible to sum up different goods. For example, it is not possible to add potatoes to tomatoes in order to obtain a meaningful total required to calculate real economic growth.  

Economic data that we are accustomed to has nothing to do with real economic growth as such. It is monetary turnover deflated by a dubious price deflator. This means that what is labelled as economic growth is in fact the growth rate of a distorted monetary turnover data, which is erroneously called total real output. 

The National Income and Product Accounts (NIPA) framework is based on the Keynesian view that spending by one individual becomes part of the income of another individual. The spending of the purchaser is the income of the seller. From this, it follows that spending equals income. So, if people maintain their spending this keeps overall income going. To establish real income the total monetary income is divided into the average price of goods and services. There is however a problem with this.  

The whole idea of a price index is based on a view that it is possible to establish an average of the prices of goods and services. Suppose two transactions were conducted. In the first transaction, one loaf of bread is exchanged for $2. In the second transaction, one litre 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 litre 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 litre of milk. 

Note that, the increase in the supply of money affects the total amount of money spent. Consequently, the greater the expansion in the money supply, all other things being equal, the more of it is going to be spent and therefore the greater the national income is going to be.  

In this framework of thinking, more money means more spending which leads to a stronger economic growth. Observe that what we have here is an increase in the monetary turnover because of the monetary pumping deflated by a dubious price index, which is presented as a strengthening in real economic growth.  In addition, we have here an increase in general prices because of the monetary pumping.  Hence, it is not surprising that we observe positive association between the so-called economic growth and price inflation. 

This in turn means that to establish the valid relationship between the production of goods and the prices of goods we must rely on the definition of prices and not on statistical correlations. From this, one could deduce that the increase in the quantity of goods for a given amount of money is going to result in less money per unit of the good. This in turn means that the relation between changes in the production of goods and changes in prices must be inverse, all other things being equal.  From this, we can also deduce that it is erroneous to suggest that a stronger economic growth must lead to higher price inflation.  

As long as the pool of real savings is expanding, Fed policy makers can get away with the illusion that they can grow the economy. Once however, the wealth generation mechanism is damaged due to the Fed’s relentless tampering the illusion that the Fed can grow the economy is shattered and the economy sinks into a black hole. Any attempt by the Fed to revive the economy by means of massive monetary pumping only makes things much worse.  

Why statistical correlations cannot identify the facts of reality 

Note that most commentators are likely to suggest that we are ignoring the facts of reality here by just paying attention to the essence of prices whilst ignoring statistical correlations. 

We maintain that irrespective of correlations without establishing what price inflation is all about i.e. without providing the definition, various correlations are of not much help. It is not possible to establish facts by gazing at the data without a theory.  

On this Ludwig von Mises held that the data is an historical display and by itself cannot provide the analyst with the facts regarding the real world.  By Mises, in Human Action pp. 41-49 

History cannot teach us any general rule, principle, or law. There is no means to abstract from a historical experience a posteriori any theories or theorems concerning human conduct and policies.   

In The Ultimate Foundation of Economic Science p. 74, Mises argued that, 

What we can “observe” is always only complex phenomena. What economic history, observation, or experience can tell us is facts like these: Over a definite period of the past the miner John in the coal mines of the X company in the village of Y earned p dollars for a working day of n hours. There is no way that would lead from the assemblage of such and similar data to any theory concerning the factors determining the height of wage rates. 

The purpose of a theory is to establish the essence of the subject of investigation. Once the logic of a theory is established as sound, no statistical correlations are required to confirm it. Correlations could be useful for illustrations purposes remembering though that correlations neither confirm nor refute a particular theory.  

Hence, to make the sense of the data there is the need to have a theory beforehand that will guide the analyst regarding the interpretation of the data.  

According to Ayn Rand, 

A theory is a set of abstract principles purporting to be either a correct description of reality or a set of guidelines for man’s actions. Correspondence to reality is the standard of value by which one estimates a theory. If a theory is inapplicable to reality, by what standard can it be estimated as “good”? 

Furthermore, covering a theory with a mathematical dress is not going to make it more scientific and valid if it runs contrary to the essence of the subject of investigation. According to Mises in The Ultimate Foundation of Economic Science p. 74 

The data of history would be nothing but a clumsy accumulation of disconnected occurrences, a heap of confusion, if they could not be clarified, arranged, and interpreted by systematic praxeological knowledge. 

Conclusion 

We suggest that it does not make much sense that genuine economic growth can lead to general price inflation. The positive association established by mainstream economics is due to the flawed statistical data derived from an erroneous framework.    

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