Rational Capitalist on Facebook

Saturday, April 12, 2008

Inflation Ignorance All Pervasive

The April 10 front page article in The Wall Street Journal declares:

"Inflation is back. After several years of relative stability, a wave of rising pries is washing over the world economy.

"Some of the factors driving inflation vary from country to country; union-negotiated wage hikes in Germany, pork shortages in China, an electricity squeeze in South Africa, pay rises for civil servants in India.

The author, Andrew Batson, goes on to cite anecdotal evidence from around the world demonstrating that prices are generally rising. He attributes this to everything from crop usage for alternative energy, to increasing demand from China and developing countries, to the weakening US Dollar, to increased economic "globalization". Lo and behold, he even cites "years of easy credit earlier this decade-the result of a global quest to avoid falling prices, or defation" to be "a contributing factor."

After discussing "pricey cab rides" in California, German wage gains, and even increasing food prices for nomadic herders on "Mongolia's steppes", he concludes partially that "Central banks, especially the Fed, are hoping that slowing growth in the U.S. and Europe will ease inflationary pressures globally, especially when fast-growing emerging economies begin to feel the slowdown's pain."

This article, which appears on the front page of the most important business periodical in the world, betrays complete ignorance of the nature, cause, and even meaning of inflation. Furthermore, should we be concerned if not outraged that our own Fed is "hoping" for "slowing growth"? It doesn't surprise me that the average American knows little about the meaning or nature of inflation but it is shocking that an economics reporter from the Wall Street Journal, policy makers at the Fed, and all the other various "experts" we see trotted out in the mainstream media could be so ignorant. This appalling article is testament to the sorry state of modern economics and to social sciences in general (which I discussed previously in my post Reality Strikes).

Here is a very simple example which serves to illustrate a few key points. Say you have $100 in your pocket to spend on various things. And let's say, for example, that you really need to buy some Chinese pork. Let's also say that pork is in really short supply so its price suddenly goes up to $100 per piece of pork. That means that all of your money must be spent on pork but you now have no money to spend on other things. Consequently, there would be less demand for non-pork items and the price of non-pork items would tend to decrease. In other words, a decreased supply of one commodity (which tends to increase its price) cannot cause a general price increase of all commodities as it tends to be offset by falling prices elsewhere.

What could cause a general price increase across all commodities? Let's say that the supply of money was rapidly increased. The increase in the supply of money would increase demand for all things. You could suddenly buy the more expensive pork and you would have money to buy other things. This increased aggregate demand would tend to increase the price of every commodity as the newly created money is spent and respent. A further effect is that if the supply of money continually increases it causes people to tend to want to hold smaller money balances which accelerates price increases even further.

When people discuss inflation they typically have in mind the idea of generally increasing prices. However, inflation should not be thought of as "increasing prices" nor should deflation be thought of as "decreasing prices." To do so, it to mistake the symptom for the cause. Quoting The Government Against the Economy (p. 2-3) by George Reisman:

"Rising prices are merely a leading symptom of inflation, not the phenomenon itself. Inflation can exist, and , indeed , accelerate, even though this particular sympton is prevented from appearing. Inflation itself is not rising prices, but an unduly large increase in the quantity of money, caused, almost invariably, by the government. In fact, a good definition would be : an increase in the quantity of money caused by the government. A virtually equivalent definition would be: an increase in the quantity of money in excess of the rate of which a gold or silver money would increase. These two definitions are virtually equivalent, because without government interference in money over the course of our history, the supply of money today would consist mainly or even entirely of precious metals and fully backed claims to precious metals. The increase in the supply of such a money would almost always be quite small and at all times would be severely limited by the high costs of mining additional quantities of the precious metals. Rising prices as a chronic social prolem are a consequence of governments overthrowing the use of gold and silver as money and putting in their place unbacked paper currencies and checking deposits whose quantity can be increased without limit and virtually without cost."

Therefore, when Mr. Batson was discussing price increases throughout the world, he was simply citing symptoms of inflation not elucidating their cause. Wage rate increases, food price increases, energy price increases, a weakening dollar, are all effects of the government's inflation of the money supply. The government accomplishes this increase in money through the Federal Reserve. When the Federal Reserve lowers interest rates it means it sets the target for the Federal Funds rate (the overnight rate that banks charge each other for loans) lower. It accomplishes this by buying government securities on the open market. The trick is that when the Federal Reserve buys the securities, it pays for the securities with money it creates (it simply puts an electronic entry in its computer system stating that the member bank now has the money). The Federal Reserve can attempt to control the money supply in this way by increasing reserves (buying securities with fake money) or decreasing reserves (selling securities to take money out which it practically never does). Data shows that the government has been rapidly increasing the money supply for the last several years. This has had the effect of causing price increases in the U.S. and around the world.

Another (Keynesian) fallacy that is implied in the article is the belief that slowing the economy will relieve inflationary pressures. The economy is slowing now and is in a recession yet prices are everywhere increasing. One of the causes of this slowdown is inflation. Inflation destroys capital in myriad ways including inducing malinvestment as we have observed with the housing crisis. As I mentioned above, it also causes individuals and firms to hold smaller money balances as credit is made easily available. When the government stops or dramatically slows the inflation, many investments are seen to be malinvestments. If this effect is widespread (as it has been with housing) then these firms must begin to rebuild their cash holdings. Firms that were actually lenders of funds may now actually become seekers of funds as the leverage unwinds. In other words, the entire economy gets a margin call. This generally leads to widespread bankruptcies and unemployment as we are now witnessing.

The idea that economic growth and price increases are necessarily related and vice versa is absurd. Under a gold standard, the economy could grow dramatically and prices in real terms would tend to decrease. This is because production in other industries tends to be similar or greater to the production and mining of precious metals. The author of this article would deride this phenomenon as "deflation" however decreasing prices if not combined with unemployment and widespread bankrupticies is equivalent to getting richer as Dr. Reisman points out in his post Deflation and the Gold Standard. If your dollar can buy more stuff (because everything is going down in price) then you are getting rich even if the amount of dollars you own is the same. Consider computer prices. It is well known that computer prices have decreased dramatically, i.e., you can buy way more computer for the same or less money than you could years ago. This means you are richer in terms of computers. It is productivity that makes us rich not necessarily the amount of "dollars" you hold. If you had a billion dollars 30,000 years ago would you have considered yourself rich? Productivity means that goods and services can be made available for less effort. This is what really increases our standard of living. In this way, a poor person in the U.S. today lives better than most kings a hundred years ago.

In a previous post "Wishing for Non A", I discussed Ayn Rand's idea that all the evil in the world at root is caused by people who desire reality to not be what it is. Well, here we go again. Inflation is based on the idea that all you have to do is create paper money and somehow this will make everyone richer. It is an attempt to contradict the laws of nature. Production is the basis of wealth. Money represents wealth, it does not cause it. Furthermore, it is this contradiction that leads to the Fed bankers "hoping" for "slowing growth." If you believe that economic growth somehow causes price increases, then you will be led into the grotesquely evil position of wishing that the economy slows down to stop prices from increasing. There is no reason why the economy cannot continue to grow indefinitely without boom-bust cycles. If human beings produce more wealth why wouldn't our standard of living continually increase without interruption? All we need is money that is real, i.e., precious metals, that is not subject to artifical increases and decreases by our ingenious government masters.

No comments: