Wednesday, September 16, 2009

Inflation: What it is and what it is not

Presently, there is much debate going on about whether we now face inflation or deflation, and among the fringe like me, whether we may in fact be facing inflationary or deflationary collapse. You'd think that with a century of economic philosophy and know-how under their belts, the community of economists would be able to arrive at a simple answer to such a straightforward question. But you'd be wrong. What is even more surprising is that in the face of the inability to give a straight answer to such a basic question, there is still the slightest shred of faith in our economic technocracy to plan and regulate our markets in anything like a beneficial manner. The fact is, economists can't even agree on what the terms inflation and deflation mean. Inspiring, isn't it? Actually, this disagreement is a big part of the problem. It needs a solution. I'll try not to bore you with too many details, but a basic discussion about what all this means might just help to clear up a lot of the nonsense. Inflation as Rising Prices Mainstream economists define inflation something along the lines of "a general increase in the price level." If one price rises, say, on a barrel of oil, it is not considered inflation, but if overall prices that we encounter everyday are all rising together, it suddenly is. Deflation would naturally be the opposite. The phenomenon of generally rising prices is loosely attributed to an increase in the money supply over the long term, but it is acknowledged that over the short term, many other forces can and do have a much larger influence. Among this crowd the most important economic statistic for describing inflation or deflation is the Consumer Price Index (CPI). This is a description of the price movements of a "representative basket of goods" from data compiled regularly by the Bureau of Labor Statistics (BLS) . Setting aside disagreements about just what "representative" means and what should go into the index, plus the validity of the various changes that have been made over the years, this does on first glance seem to be a straightforward measure of "a general increase in price levels." No doubt, the prices of everyday goods we will be buying every day as consumers are a very important consideration to us as we go about our daily business and make plans for our future. But does our interest in a particular statistic render it valid as a descriptor, let alone a determinant of economic cause-and-effect? Does this statistic and others like it, which our technocratic overlords use to determine the "right" policies going forward, actually have any relevancy to the decisions they are actually making? Very, very little, in my opinion. Basing economic policy on the movements of the CPI and other suchlike statistics is a bit like a soccer coach basing his decisions on the physical attractiveness of his players. This may actually be of interest to him, a somewhat creepy thought depending on the circumstances. It may even be important to his players, who might have joined the team for the purposes of getting in better shape or losing weight. But a team which forms the basis of its training regimen around the importance of beauty as a key determinant of the ability to play soccer well isn't likely to excel at the sport itself. On average, a team with players that are more physically fit would probably do slightly better than one that allowed its players to get quite overweight, but for the most part makeup, perfect hair, and plastic surgery aren't going to do much for dribbling and passing skills. Attractiveness is only tangentially correlated with performance. If such a team's skills are put to the test in the real world by engaging in competition with another soccer team that has more realistic ideas, it is likely to receive a sound beating. Likewise, the importance that the CPI and other indices may have for us as consumers does not necessarily translate to importance in understanding the behavior of an economy. Instinctively, we understand that an increase in the money supply should translate to an increase in prices, yet in practice this very often doesn't seem to be the case. Mainstream economists have figured out pretty well when the money supply can be increased with very little effect on consumer prices. During the height of the financial crisis last October, even some nominally conservative commentators called for "reflation" of the economy through expansionary monetary policies, knowing full well that there was no immediate danger of inflation. They were right; there was no immediate danger of consumer price inflation. But that does not mean that there are no consequences for increasing the money supply. I return again to the idea that increasing the money supply should increase prices. We know this should be the case. But if it is not increasing consumer prices at this time, what prices are being increased, and what will the effects of this price distortion be? Once you have asked this question, you are halfway to understanding the shortcomings of mainstream economic theory and the basic premises of the Austrian school of thought. Inflation as Monetary Expansion We have seen that defining inflation in terms of prices does not give us the most useful definition in terms of understanding economic cause-and-effect in a straightforward manner. Now, we can move on to a more useful definition. The Austrian School defines inflation in terms of cause rather than effect. Inflation is taken to be, simply, an increase in the money supply. Changes in prices levels such as measured by the CPI might be talked about in terms of "price inflation," and increasing levels of credit as "credit inflation," but the word inflation itself is always in reference to increasing money supply, and sometimes to the host of economic phenomena that accompany such increases as "an inflation." Price movements, whether taken individually or collectively, are irrelevant. Occasionally, you will encounter the term "monetary inflation" to differentiate this view of inflation from the mainstream price-level view. And for the record, I occasionally lapse into the common usage. But, from a purely philosophical standpoint, inflation is taken to refer to an increase in the money supply and the view that increasing prices are the sole indicator of inflation is rejected. Some Effects of Inflation Once we have rid ourselves of the notion that inflation is determined in terms of prices, and begin to logically work through the economic consequences of increasing the money supply, a whole host of economic phenomena begin to make more sense. First of all, we will realize that the "new" money must enter the economy from somewhere, and that the price increases we have been looking for will begin here. In the old days, when gold literally was money, it was a well-known phenomenon that when a gold deposit was discovered, prices for mining supplies and everyday items near the deposit would begin to rise dramatically. As a consequence, it also became well known that one didn't have to become a miner to partake in the find -- plenty of gold could be had by supplying the miners with goods! Only part of this price distortion effect was due to "gold fever" convincing would-be miners to part with more money than they might otherwise have deemed prudent. A large share was simply the effect of more gold being in circulation around the mines that were producing it. The gold mining community was able to bid resources away from surrounding areas with the gold it was producing because it could afford to pay higher prices for goods. It spent the "new gold" first, before it had a chance to spread out through the rest of the economy. High prices have been a California staple for a very long time! Today, the sources of new money are government through the Federal Reserve and the banking system through fractional reserve banking. By spending the "new money" first, they are able to bid resources away from other bidders. One of the effects is ballooning government, which most are familiar with. Another is a ballooning financial sector. More subtly, the new money enters the economy through credit markets. Goods bought on credit, typically investments, capital goods, real estate, and the like, tend to see their prices increase first in response to a monetary expansion. Consumer goods, which aren't typically bought on credit, must wait for the "monetary injection" to work its way through the rest of the economy. There are knock-on effects as well: once the prices of certain goods have taken off, for example houses, suppliers of those goods, such as homebuilders, begin to see improved profits and start expanding their businesses in response to this "new demand." These price and profit changes send stock markets on a roller-coaster ride. And when the supply of new money suddenly dries up, usually as a result of the technocrats recognizing the monster they have created with their price distortions, the effects reverse. Credit becomes scarce, banks feel the pinch, prices fall, and workers get laid off. But note here -- falling prices are not the result of deflation, or a decrease in the money supply. The distorted price levels of an inflating economy can only be sustained by continuous flow of new money. Once this slows down or stops, the party is over. Reduction of the money supply is not necessary for a fall in prices to occur. Inflation has a great many other effects as well, from the boom-bust cycle to the expansion of welfarism and despotism to the erosion of social mores. These are far too numerous to go into here, but suffice it to say, virtually all are a bane to civilized society. Conclusion Inflation, while popularly understood as a general increase in price levels, is far better understood in economic terms as an increase in the money supply. This is the Austrian view of inflation. In understanding inflation on these terms, we focus on an important determinant of economic causation, rather than on a statistic of narrow practical interest and little economic consequence. Short term price changes are far less important to understanding the economy and making predictions than monetary policy and changes in the money supply. An understanding of the routes of entry of the "new money" that produces inflation can help to illuminate the practical consequences of increasing the money supply. By "uncoupling" our view of inflation from price changes, and thinking of price changes on their own, separate terms, we may better understand such disparate phenomena as the underpinnings of the business cycle, the stock market, political economy, and the broad cultural developments that result from the erosion of social mores. Through a better understanding of these effects, we may also make better plans for our financial future.

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