Friday, February 15, 2008

Inflation - part 2/2

In part 1 we saw that defining inflation as generally rising prices is a red herring. We argued that the definition is meaningless because it cannot be objectively determined. However, rising prices are a phenomenon we observe today, and one that greatly impacts our lives. Ultimately, our goal is to explain rising prices. It is insufficient to simply deconstruct the mainstream view of inflation, we must offer an alternate theory, one that hopefully better explains price movements.

Supply Shocks and Water Levels

Mainstream economists usually attribute inflation to supply shocks (cost-push), increased aggregate demand (demand-pull), or other exogenous circumstances. This is false. A supply shock is a short term event that affects a small segment of the economy; for example, a hurricane damaging an off-shore oil rig temporarily reducing the supply of oil. Price is the intersection between supply and demand. If supply falls and demand is unchanged, then prices must rise in order for the market to clear. This much is true. However, since oil prices have risen, consumers have less money to spend elsewhere. Their demand for other goods and services thus falls. But the supply of those goods and services is unchanged, therefore prices must fall in order for markets to clear. Thus any rise in the price of oil is accompanied by a fall in the price of other goods and services. The rise/fall will not balance perfectly since there is always the human element to consider, but that is not as important for the present discussion and will be sidelined for the present. What is important is that the price of oil rose, while the prices of other goods and services fell. There was no "general rise in prices." (The same logic holds if a sector suddenly experiences an increased demand.)

Consider the following thought experiment. Imagine a glass partially filled with water. Draw a line around the glass at the level of the water. If you tilt the glass in one direction, the water level rises above the line on the tilted side. However, the water level falls below the line on the other side. The average level is unchanged. This is analogous to the supply shock. Think of the water level as the price level. Tilting the glass (the supply shock, or increased demand) raises the water level on one side (the sector experiencing the shock) and reduces the water level on the other side (the rest of the economy) as water flows between the two sides. We cannot raise the average water level simply by tilting the glass.

Too Much Money Chasing Too Few Goods

Let us continue with our thought experiment. Imagine our goal is to raise the water level. How can we achieve this? The obvious answer is to add more water. Another answer, perhaps less obvious, is to pour the existing water into a narrower glass. There is little else we can do. The same observation holds when it comes to rising prices. In our experiment, the water level represents the price level, the amount of water represents the money supply, and the width of the glass represents the size of the economy. To raise the price level (the water level), we must print more money (add more water) or shrink the economy (use a narrower glass). Any sort of tilting (supply shock, or increased demand) will result in money flowing towards that sector from other sectors causing rising prices in that sector and falling prices elsewhere. There cannot be a "general rise in prices".

Many mainstream economists recognize this. To circumvent the problem, there is the oft cited canard of increased aggregate demand. To simplify: every sector of the economy experiences a simultaneous rise in demand. As supply remains constant, prices must adjust upward for markets to clear. Voila!, generally rising prices. They claim the water level has risen without additional water or changes to the glass. So what magic is this? In fact, there is no magic, only faulty reasoning. Recall from our earlier discussions on money that every trade is an exchange of goods or services for other goods or services. An increased demand for chocolate is supported by an availability of, say, cell phones to be traded for it. Without the cell phones to trade for the chocolate, the demand cannot be financed. Thus, increased aggregate demand is a chimera. It is impossible without increased aggregate supply as a source of financing. (Btw, this is the essence of Say's law, that "supply constitutes demand", not that "supply creates demand" as Keynes erroneously stated.)

Our thought experiment demonstrates that a rise in prices is essentially too much money sloshing around the system chasing too few goods. If the growth in money supply exceeds the growth in the real economy, then the average level of prices will rise, and vice versa (straight from the horses mouth). Armed with this understanding we can conclude that the rise in prices since 1913 resulting in a dollar worth only 4 cents today is simply the Federal Reserve printing too much money. Rather than being an inflation "fighter", the Fed is the root cause of inflation. In fact, looking at price indices prior to 1913, we find the price level is essentially unchanged for large periods of time. See for yourself. The standout in the graph is the parabolic growth since 1971 when Nixon closed the gold window. With absolutely no check on the supply of money, the Federal Reserve has inflated at an alarming pace causing large price increases. In the last decade alone the money supply has more than quadrupled, with M3, the broadest measure of money supply, currently growing in the double digits.

The Complete Picture

We have now formally defined inflation as growth in the money supply. This is the correct definition because the fundamental nature of inflation is not rising prices, but falling purchasing power of the currency. Prices of goods may rise, but the truth is that the price of the currency has fallen. All goods have a price, the dollar included. While the prices of goods and services are generally expressed in units of money, the price of money is expressed in units of goods and services. The price of a tomato is the number of dollars that must be traded for it. Similarly, the price of the dollar is the number of tomatoes (or bananas, or cars, or whatever) that must be traded for it. Generally rising prices is a euphemism for falling dollar.

When the central bank increases the money supply, the effect is upward pressure on prices. More water has been added to the glass. This should give us pause for thought, but it is still not the complete picture. Recall that the other variable in our thought experiment was the width of the glass. Our base goal here is to understand changes in the price level. We are being sloppy if we ignore this other variable. Let us now consider all phenomena that influence the average level of prices:
  1. Inflation: defined to be growth in money supply exerts upward pressure on prices. More water is added to the glass. This is what causes generally rising prices.
  2. Productivity gains: exerts downward pressure on prices. When entrepreneurs invest in technologies or processes that increase productivity, they are able to introduce more real wealth into the economy. The glass is made wider and the water level falls.
  3. Government regulation: exerts a decidedly upward pressure on prices because it reduces the size of the economy. In our earlier discussion on supply shocks we had implicitly assumed their effect to be localized. Should the shock extend across multiple sectors or geographies, then it can no longer be considered a supply shock, but rather a system wide problem. Such system wide problems simply do not occur randomly. Hurricanes, earthquakes, tsunamis, or what-have-you do not impact the economy so as to make the glass observably narrower. Only governments through regulation or wars can achieve that end.
The interaction of these factors results in the observed rise/fall in prices. Unfortunately, it is very hard to quantify what part of the rise/fall is attributable to each cause. We can accurately measure money supply growth, but the benefits of productivity gains or the destruction of government regulation is impossible to determine as their is no yard stick in existence. Having a yard stick requires an imagination. An imagination that helps the economist understand what would have transpired had an entrepreneur not invented, or a bureaucracy not stifled, a new technology. That being said, we can make statements about the whole. For instance, with the high-tech industry where newer and better products are consistently offered at lower and lower prices, we conclude that the downward pressure from free market forces delivering productivity gains to the consumer outweighs the upward pressure from money supply growth and the relatively light regulation. Similarly, with the health care industry, where prices are rising in excess of the general economy, we conclude that the controlling effect is not money supply growth, but excessive government regulation that is stifling entrepreneurs from delivering productivity gains to the consumer. (Consider the AMA, the FDA, HMO's, and the tax structure, just as starting points.)

The Hidden Tax

Although inflation causes generally rising prices, it should not be understood as detrimental to all parties involved. It is highly lucrative for the government and the banking industry. When new money is printed (today, created electronically), it greatly benefits the first recipient because assimilating the new money into the economic organism takes time. Those first recipients (government and banks) can purchase goods and services at the old prices. As the money slowly works its way through the economy prices are bid up. Eventually when it reaches the salaried workers, prices have mostly adjusted. This process is a hidden tax on salaried workers, or anyone who receives the money late in the cycle. It is especially detrimental to those on fixed incomes, such as pensioners. Not only does the government understate the effects of inflation in its official numbers, any price decrease that would have occurred as a result of productivity gains are denied to the consumer as well. Inflation is nothing but wealth transfer. The government prints money and buys stuff with it. Prices rise and the salaried worker can buy less stuff. All the stuff the salaried worker could have otherwise bought has accrued to the government. Simple. Politically, it is far more palatable than raising taxes because the process is badly understood and well obfuscated.


Our goal at the outset was to explain rising prices, and we have. Inflation, money supply growth, is the primary cause, with government regulation having sector specific effects depending on how malignant. In a free or lightly regulated market with commodity money, the tendency will be towards generally falling prices. This is a boon to salaried workers and those on fixed incomes who will experience a higher standard of living. See the period 1820 to 1860 here. On the contrary, an inflationary policy causes standard of living declines, which is corroborated by the fact living standards pretty much topped in the early 70's (Sorry, I've been unable to track down the exact statistic. If anyone has it, please forward it to me.)

In the addendum, I will examine the chart of the CPI more closely and attempt to explain the various periods.


Inflation in one page, by Ludwig von Mises.


J said...

First of all, thanks for writing this document, I am finding it enlightening and useful. Though I would like some clarification on some things you have written...

Under "Inflation 2/2", "Too Much Money Chasing Too Few Goods" paragraph 3 you wrote "If the growth in money supply exceeds the growth in the real economy, then the average level of prices will rise, and vice versa".

I have two questions...

1. WHY does this happen? Could you elaborate? What is the relationship between increased money supply and rising prices?

2. What is it you refer to when you say the "real economy"? Is there a 'fake' economy of sorts? What is the difference between the two?

My email address is

I would really appreciate you taking the time to answer as I am keen on understanding these concepts.

Kind regards

Raja said...

Jon - thanks for the kind words and apologies for the delayed response.

By "real" economy I mean all goods and services. People tend to confuse money for wealth. It is not. It is only a claim on wealth. "Real" wealth is goods and services. See my articles on money for more details.

Now, when the amount of money in the system is growing faster than the production of goods and services, the prices for those goods and serviced will rise and vice versa. For example: assume we are only producing apples. Currently 10 apples are produced every year and there are $10 in circulation. If the number of apples produced doubles to 20, what happens to the price of an apple? What about when dollars in circulation quadruple to $40?

That is the essence of inflation, when money supple growth exceeds economic growth.

Frank S said...

Thank you for the article. I have a couple of questions about this:

1) How does non-fiat money solve the problem? If the glass widens, for instance, how can we ensure that we find enough gold to keep prices from dropping?

2) Most mainstream economists seem to think that deflation is worse than inflation. Can you talk more about this, and perhaps indicate why you think it is wrong?

3) It's it mostly a wash anyway? I may be able to buy fewer apples with my dollar, but I am paid more dollars. Sure, banks get access to the money first, but as net lenders, they also have their loans repaid with inflated dollars. It seems that inflation only really matters depending on which side of the saving-lending / borrowing fence you are on.