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The fall in the headline
consumer price index (CPI) in April for the second consecutive month has
raised concern that the US economy might have fallen into a deflationary
black hole. Year-on-year the consumer price index (CPI) fell by 0.7 per cent
in April after declining by 0.4 per cent in the month before. For most
experts the emergence of deflation poses a serious threat to the economy. It
is held that a fall in prices causes consumers to postpone their expenditure.
Furthermore deflation also raises real interest rates and the debt burden,
thereby depressing further the overall demand for goods and services, so it
is argued. After falling to negative 3.6 per cent in July 2008 the real fed
funds rate has been in an uptrend climbing to positive 0.9 per cent in April
this year.
So how does one counter
deflation? Some economists are of the view that one way of doing this is
through policies that promote higher rate of inflation. According to Harvard
professors of economics Gregory Mankiw and Kenneth Rogoff a higher rate of
inflation will set the platform for a decline in real interest rates and for
an increase in current consumer expenditure. Additionally a higher rate of
inflation will work towards the reduction of the debt burden. As a result
this will provide a necessary boost to economic activity. (Bloomberg.com,
May 19, US needs more inflation to speed recovery, say Mankiw, Rogoff)
So what is the level of
inflation required to pull the economy from a deflationary black hole? Some
experts such as Rogoff hold that 6 percent is the right figure. “I'm
advocating 6 percent inflation for at least a couple of years. It would
ameliorate the debt bomb and help us work through the deleveraging
process”, says Rogoff. So it seems that in the current economic setup a
little bit of inflation is the correct remedy for the economy.
But how can it be that
something, which is normally regarded as bad news, something that destroys
the economy, can at the same time promote economic health? Our Harvard
professors don't try to provide an answer to this question. All that matters
for them is that a higher rate of inflation is going to revive consumer
outlays, which they hold is going to strengthen the economy.
Are increases in the consumer
price index what inflation is all about?
The main problem with this
way of thinking is the definition of inflation. Most economists hold that
inflation is a general rise in prices that can be captured by the Consumer
Price Index (CPI), but they disagree about the causes of inflation. In one
camp are the monetarists, who argue that changes in money supply cause
changes in the CPI. In the other camp, we have economists who argue that
inflation is caused by various real factors. These economists have doubts
about the proposition that changes in money supply cause changes in the CPI.
They believe that it is likely to be the other way around.
We suggest that the subject
matter of inflation is not rises in prices as such but the debasement of
money. Historically inflation originated when a ruler would force the
citizens to give him all the 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
to the citizens diluted gold coins.
The ruler can now use the
stolen gold and mint coins for his own use. What was now passing as a pure
gold coin was in fact a diluted gold coin. The expansion in the diluted coins
that masquerade as pure gold coins is what inflation is all about. As a
result of inflation, the ruler could engage in an exchange of nothing for
something. (He could now divert real resources 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
means here an increase in the amount of paper receipts that are not backed by
gold yet masquerade as true representatives of money proper, gold. Again the
holder of unbacked money engages in an exchange of nothing for something.
In the modern world the money
proper is no longer gold but rather paper money; hence inflation in this case
is purely the increase in the stock of paper money. Please note we don't say
that that inflation is about general increases in prices. Also note that we
don't say that the increase in the money supply causes inflation. What we are
saying is that inflation is the increase in the money supply.
Once it realized that
inflation is about the increases in money supply it becomes clear why it is
bad news. When money increases, there are always first recipients of money
who can buy more goods and services at still unchanged prices. The second
recipients of money also enjoy the new money. However, the successive
recipients derive less benefit as prices of goods and services begin to rise.
So long as the prices of
goods they sell are rising much faster than the prices of goods they buy, the
successive recipients of new money still benefit. The sufferers are those
individuals who get the money last or not at all. They find that the prices
of goods they buy have increased while the prices of goods and services they
offer have hardly moved. In other words monetary growth or inflation causes a
redistribution of wealth.
On closer inspection we can also
establish that monetary injections give rise to demand for goods and
services, which is not supported by the production of goods and services,
implying that monetary growth leads to an economic impoverishment of wealth
generators. Furthermore, monetary inflation gives rise to the menace of the
boom-bust economic cycle. Once it is established that the subject matter of
inflation is the expansion of the money stock, we can attempt to ascertain
whether the use of inflation can help to revive the US economy.
Monetary Inflation and Prices
What is the price of a good?
It is the amount of money asked per unit of a good. Observe that without
money one cannot even begin to discuss what prices are. Yet most economists
whilst discussing prices never even mention money. 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). 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.
An increase in a price of a
particular good means that more money is now paid for this good. Likewise if
for a given stock of goods an increase in the money supply occurs, within all
other things being equal, this would mean that more money is going to be
exchanged for the unit of this stock of goods. This means that the price of a
good has gone now up.
Observe that in this case the
increase in money supply i.e. inflation is associated with the increase in
prices of goods. (We have seen that most economists and commentators define
inflation as a general rise in prices, which is summarized by the so-called
consumer price index (CPI). Note again while a general rise in prices may be
associated with inflation, it is however not inflation). But now consider the
following case: the rate of growth in money is in line with the rate of
growth in goods. Consequently, there is no change in prices of goods. Do we
have inflation here or don't we?
For most economists, if an
increase in the money supply is exactly matched by the increase in the
production of goods, then this is fine, since no increase in general prices
has taken place and therefore no inflation has emerged. We suggest that this
way of thinking is false since inflation has 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.
For instance, once a king has
created more diluted gold coins that masquerade as pure gold coins he is 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 money paper 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 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.
Following our conclusion that
inflation is about increases in money supply obviously it cannot be
beneficial for the economic growth as our Harvard professors have suggested.
On the contrary, an increase in inflation results in the economic
impoverishment, by diverting real wealth from wealth generators to the
holders of newly printed money. It leads to consumption without supporting
production.
Inflation and the pool of
real savings
Is it true that inflation
helps to alleviate the debt burden in the economy? What raises the debt
burden is the declining ability of individuals to create real wealth.
Obviously then, that more inflation weakens the ability to create real wealth
and can only increase and not reduce the debt burden. Printing money can only
help temporarily the first receivers of newly printed money. It however,
cannot help all the individuals in the economy. We can thus conclude that
inflation can only raise and not lower the overall debt burden in the
economy.
That inflation is a
destructive process not always can be seen when the underlying bottom line of
the economy is still ok. For instance, when authorities are increasing the
money supply rate of growth whilst the pool of real savings is still in a
good shape — economic activity follows suit. It is easy then to
conclude that inflation and economic growth are moving in tandem. Once
however, the pool of real savings is in trouble no monetary pumping can
revive economic activity.
(Remember every activity
whether of wealth or non wealth generating nature must be funded. Funding
cannot be replaced with printing more money i.e. more inflation. Funding is
about real savings).
On the contrary an increase
in the rate of inflation as suggested by our Harvard professors only further
weakens the process of real savings formation — the key for economic
growth. Good examples in this regard are the Great Depression of 1930's and
Japanese depression of 1990's. The importance of correct definition of
inflation cannot be emphasized enough. Failing to identify i.e. define
inflation can produce nasty surprises. For instance, for most experts the key
for a healthy economy is price stability. If general rises in prices follow a
stable growth path economists are of the view that this points to a stable
economic growth.
Now we have seen that while
increases in money supply (i.e. inflation) are likely to be revealed in price
increases as registered by the CPI, this need not always be the case. We have
seen that 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. In other
words, whilst money growth is buoyant i.e. inflation is high; prices might
display low and stable increases. Clearly, if we were to regard inflation as
rises in the CPI, we would reach misleading conclusions regarding the state
of the economy. (The increase in money supply regardless of the CPI rate of
growth diverts real wealth from wealth generating activities to various
non-productive activities thereby weakening the bottom line of an economy).
On this Rothbard wrote (America's Great Depression, p. 153),
The fact that general prices
were more or less stable during the 1920's told most economists that there
was no inflationary threat, and therefore the events of the great depression
caught them completely unaware.
This means that the loose
monetary policy of the Fed back then had significantly weakened the pool of
real savings notwithstanding the stable CPI. Hence analysts who ignore
monetary pumping and only pay attention to changes in the CPI run the risk of
overlooking what is really going on in the economy. The whole idea that there
is the need for more inflation in order to revive the economy seems
preposterous given the fact that the Fed has been aggressively inflating
since the end of last year.
The yearly rate of growth of
monetary pumping as depicted by the Fed's balance sheet jumped from 3.8 per
cent in August last year to 152.8 per cent by December 2008. At the end of
April the yearly rate of growth stood at 138.6 per cent. The growth momentum
of our monetary measure AMS displays buoyancy. The yearly rate of growth of
AMS jumped from 2 per cent in August last year to 12.6 per cent in May this
year.
Conclusion
Some prominent US economists
such as Harvard professors Gregory Mankiw and Kenneth Rogoff are advocating
that the Fed should aim at a higher rate of inflation in order to revive the
US economy. So it seems that in the current economic setup a little bit of
inflation is the correct remedy for the economy. But how can it be that
something, which is normally regarded as bad news, something that destroys
the economy, can at the same time promote economic health? Our Harvard
professors don't try to provide an answer to this question.
We find this way of thinking
is extraordinary given that the Fed is already pursuing very loose monetary policy.
Following our conclusion that inflation is about increases in money supply
obviously it cannot be beneficial for the economic growth as our Harvard
professors have suggested. On the contrary, an increase in inflation results
in the destruction of economy's fundamentals and leads to economic
impoverishment.
Frank Shostak
Frank
Shostak is a former professor of economics and M. F. Global's chief economist.
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