By Dr Frank Shostak
By the popular way of thinking the policy of price stability does not always mean that the central bank must fight inflation. It is also the role of the central bank, so it is held, to prevent large declines in the inflation rate, or an outright decline in general price level. Why is that so?
On this way of thinking a decline in the price level, which is labelled deflation, weakens consumer and business expenditure thereby paralyzing economic activity. Furthermore, a decline in the pace of increase in the prices of goods and services raises the real interest rates thereby further weakening the economy. Additionally, as expenditure weakens this further raises unutilized capacity and puts additional downward pressure on the price level.
Most economists are of the view that it is much harder for the central bank to handle deflation than inflation. When inflation rises, the central bank can always “cool it off” by large increases in interest rates, so it is held.
With regard to deflation the lowest percentage that the central bank can go is the zero-interest rate. Below this percentage individuals are likely to be reluctant to lend. Now, by popular thinking the real interest rate is defined as,
Real interest rate = Nominal interest rate – Inflation rate,
from this one can also establish that,
Nominal interest rate = Real interest rate + Inflation rate
Let us say that as a result of a decline in the inflation rate from 1 percent to -1 percent central bank policy makers have concluded that a real interest rate of -0.5 percent is required to counter deflation thereby preventing an economic deterioration. At an inflation rate of -1 percent this would require the central bank to lower the nominal interest rate to -1.5 percent. Since this is below the zero percentage individuals are likely to be reluctant to lend.
Likewise, when the inflation rate is very low it can also create problems. Suppose that inflation has fallen from 2 percent to 1 percent. At a nominal rate of 0 percent, the central bank can set a target for real interest rate of –1 percent. It cannot aim at a lower real interest rate since this would imply setting the nominal interest rate to below zero.
As the economy weakens further and the inflation rate falls to 0.5 percent this will not allow the central bank to target real interest rates to below -0.5 percent.
On this way of thinking a low inflation rate, or outright deflation reduces the central bank’s ability to revive the economy. Hence, the policy of price stability must aim at a certain level of inflation, which will give the central bank the flexibility to keep the economy on the path of economic prosperity and prevent the economy declining into deflation.
The essence of all this, is that inflation is necessary in order to have economic prosperity and stability. The inflationary buffer must be large enough to enable the Fed to maneuver the economy away from the danger of deflation, or so it is held.
Mainstream economists hold that inflation at around 2 percent is not harmful to economic growth. They are of the view that the inflation rate of 2 percent seems to be good for the economy, a higher inflation rate say 10 percent could be actually bad.
Why would an inflation rate of 10 percent or higher be regarded as bad? If anything at an inflation rate of 10 percent it is likely that consumers are going to form rising inflation expectations, and according to the popular thinking, in response to a high inflation rate, consumers are going to speed up their expenditure on goods at present, which should boost the economic growth.
Inflation is not about rise in prices
Inflation is not about general increases in prices as such, but about increases in the money supply. As a rule, the increase in money supply sets in motion general increases in prices. This, however, need not always be the case.
The price of a good is the amount of money asked per unit of it. For an unchanged quantity of money and an expanding quantity of goods, prices will actually decline.
The reason why inflation is bad news is not because of increases in prices as such, but because of the damage inflation inflicts to the wealth-formation process. Here is how.
The chief role of money is to fulfill the role of the general medium of exchange. Money enables individuals to exchange something they have for something they prefer more. Before an exchange could take place, individuals must have something useful that they could exchange for money. Once they secure the money, they could then exchange it for the goods they want.
Now, consider a situation in which money is generated out of “thin air”. This new money is not different from the counterfeit money. The counterfeiter exchanges the fraudulent money for goods without producing anything useful. He in fact exchanges nothing for something. He takes from the pool of goods without contributing to the pool.
The economic effect of money that was generated out of “thin air” is the same as that of the counterfeit money — it impoverishes wealth generators. The money generated out of “thin air” diverts wealth towards the holders of new money. This weakens wealth generator’s ability to generate wealth and this in turn leads to the weakening in economic growth. Note that as a result of the increase in the money supply what we have here is more money per unit of goods, and thus, higher prices, all other things being equal.
Again, what matters is not price increases as such but the increase in money supply that sets in motion the exchange of nothing for something or “the counterfeiter effect”. Note again, the exchange of nothing for something weakens the process of wealth formation. Therefore, anything that promotes increases in the money supply can only make things much worse.
Obviously then countering a declining growth rate of prices by means of an easy monetary policy i.e., by generating inflation, is bad news for the process of wealth generation and hence for the economy.
Furthermore, if a decline in the growth rate of prices emerges on the back of the collapse of non-productive bubble activities in response to softer monetary growth, then this should be seen as good news. The less non-productive bubble activities the better it is for the wealth generators and hence for the overall pool of wealth.
Note again, if a decline in the growth rate of prices emerges because of an expansion in goods for a given stock of money obviously this is great news since more individuals could now benefit from the expanding pool of goods. Hence, contrary to the popular view, a fall in the growth rate of prices is good news for the wealth generating process and hence for the economy.
According to Rothbard,
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. Forcible propping up of the price level prevents this spread of higher living standards.
Also, according to Joseph Salerno,
….. Historically, the natural tendency in the industrial market economy under a commodity money such as gold has been for general prices to persistently decline as ongoing capital accumulation and advances in industrial techniques led to a continual expansion in the supplies of goods. Thus, throughout the nineteenth century and up until the First World War, a mild deflationary trend prevailed in the industrialized nations as rapid growth in the supplies of goods outpaced the gradual growth in the money supply that occurred under the classical gold standard. For example, in the US from 1880 to 1896, the wholesale price level fell by about 30 percent, or by 1.75% per year, while real income rose by about 85 percent, or around 5 percent per year.
Conclusion
A policy of generating inflation in order to enable central bank policy makers to guide economic growth leads to boom-bust cycles and economic impoverishment. The emergence of deflation is always good news since it is in response to the liquidation of various activities that cause the erosion of the wealth generation process.
