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Thursday, April 29, 2010

Can Prices Go Down during Inflation? A Critical Lesson

Let's say that a loaf of bread costs $2.00. Due to massive improvements in technology and productivity, bread producers begin producing bread rapidly and efficiently. All else equal, say bread prices decline to $1.00 per loaf.

Now let's say that the government inflates the money supply and bread prices rise to $1.50 per loaf.

In this case, inflation has caused prices to rise and consumers pay more for bread than otherwise. However, in absolute terms we measure an actual decline in bread prices - from $2.00 to $1.50.

In other words, even though there was inflation, prices have declined in absolute terms. Prices have not gone up in nominal terms, but they have risen more than they would have otherwise (absent the inflation of the money supply).

This is a crucial point because it illustrates the nature of inflation and points to why so many people misunderstand this critical concept. Inflation is not "increasing prices" as virtually every modern economist would define it. Inflation is an increase in the quantity of money above the increase in the quantity of precious metals. Prices will tend to increase due to inflation as the additional supply of money chases the same amount of goods. But, again, all this means is that prices tend to be higher than otherwise - it does not mean that prices must rise when measured in nominal terms.

Inflation is destructive for many reasons. Therefore, it is crucial to determine when inflation is occuring to properly analyze and account for its likely effects.

Today's empiricist economists and their colleagues in government, who do not understand the nature of inflation, will simply measure price aggregates. If prices are going up, they call it inflation. If prices are going down, they call it deflation. This completely misses the point because it ignores cause and effect. This leads them to ignore the disastrous impact of inflation as long as nominal prices are not rising rapidly. Or, it causes them to attribute healthy and wealth creating price declines to deflation, resulting in policies which act to further destroy wealth.

This is a crime. Without inflation of the money supply, prices would be much lower. Price decreases due to increasing productivity, such as the price decreases observed in the computer industry, represent massive increases in real wealth to everyone. Real wages or purchasing power is simply how much work you have to do to in order to get what you want. If it takes a week to work for a loaf of bread you are poorer than if takes an hour of work to buy a loaf of bread. In effect, if prices remain "stable" or don't increase rapidly, the government stands back and says "see, we have done a good job at keeping inflation under control." However, in the absence of this inflation, prices would be much lower than otherwise. Furthermore, capital would not be misallocated as a result of investors chasing distorted nominal price increases.

One of the ways inflation is destructive is by distorting prices signals, causing investors to allocate capital to areas of the economy that appear profitable but in fact are not. This clearly happened in the housing sector, where investors poured money into real estate development on the expectation that housing prices would never decline. In fact, long term increases in housing prices has generally created the illusion that housing is an investment asset when in reality, it is a depreciating consumer good - a point I analyzed here.

Today, housing prices should be declining as investors liquidate positions in housing. Banks should decline in value as the value of their real estate portfolios are marked down. These price declines represent a healthy process of liquidation of the previously malinvested capital. Price declines signal to the market that this is an unprofitable area that has been over capitalized. The market is saying: "get out and put your money elsewhere."

However, the government is doing everything in its power to stop this process. Why? Because price declines, rather than being seen as part of a curative recession, are equated to deflation which, according to modern economists, must be stopped at all costs. The Federal Reserve has propped up unprofitable banks with counterfeit money in hopes that the banks stay solvent and that real estate prices appreciate. The Federal Reserve has essentially removed over $1 trillion of mortage backed securities from the market and placed it on its balance sheet. Since the Federal Reserve has paid for these securities with counterfeit money, they have essentially redistributed the losses to everyone who holds wealth in dollars since they have done so through inflation.

But "wait" says the modern economist. "Prices are not rapidly increasing in aggregate so there is no problem with inflation."

Wrong. It is inflationary every time the government counterfeits money. This money, whether or not is causes nominal price increases, causes all the attendant effects of inflation by causing prices to remain higher than otherwise. These relatively higher prices, among other things, signal or cause investors to stay invested in real estate when they would otherwise liquidate. It is propping up unhealthy banks that need to be liquidated. More broadly, these relatively higher prices signal to investors that everything is ok when, in fact, it is not.

Recessions are a liquidation phase in which previously misallocated capital gets reinvested in more productive areas. Any distortions of prices caused by the government's intervention in the marketplace through both the creation of credit out of thin air or through more direct intervention, merely delays the inevitable. Rather than allowing a rapid liquidation and consequently, a rapid return to economic growth upon a sound foundation, these interventions encourage the disease to fester endlessly (see Japan from 1990 to the present), tying up much needed capital in failing enterprises, ultimately reducing the productivity of our economy and destroying real wealth.

I will return to this topic in my forthcoming post, Boom and Bust Part 4, in which I will analyze the Great Depression, and show why misinterpretation of this seminal economic event based on flawed philosophy, in part, leads to these flawed ideas.


scott said...

again you make a great point!

Mo said...

interesting. I opened my local newspaper today and found that our telecom company is increasing the price of their wiring maintenance service. They cited inflation as the reason.