Wednesday, May 06, 2009

Inflation is here

One very large problem with the bailouts is that there is absolutely no way to determine how much money will need to be created to solve the crisis. This presupposes that some magical amount does in fact exist; but surely even the most ardent Keynesians would admit that if we printed too much money, the currency would become worthless through hyperinflation.

To give an obviously absurd example, but one which nonetheless demonstrates the point, if the Obama administration agreed to mail a one billion dollar check to every American, although a naive glance might suspect that this would add wealth to the economy, the reality is that the dollar would lose virtually all of its value. And because this would happen so quickly, it is likely that the price structure would be destroyed completely; like the German Papiermark, it might be burnt for warmth, but it would have lost all real value as an economic medium of exchange. So while the usual parties clamor about a deflation trap, there is a real risk of hyperinflation, too--especially when one considers that the money supply has been doubled in the last several months.

Armed with similar information--and with an extensive economic background with goodly doses of Mises and Rothbard--Congressman Ron Paul recently voiced his concerns about runaway inflation to Federal Reserve Chairman Ben Bernanke:

I have a couple of questions, but first I want to mention that I find it awfully frustrating at times when we always talk about inflation and we only talk about the prices and say, “We have prices under control, there is no inflation”. We have to realize that the monetary base, the liquidity was doubled in a few short months. To me there is a lot of inflation out there. It’s already inflated, we’re in the midst of inflation. Because the prices haven’t gone up doesn’t mean we don’t have the distortion.

Now since both Paul and the Chairman are well versed in economics, and since his time is short, he doesn't always define his terms--though I'm betting he will in his forthcoming book. But in order to understand his point, it might be helpful to give a definition. For while the tendency is to gauge inflation by looking at prices--by using a fraudulent CPI--an increase in prices is actually a symptom of inflation. The great Austrian economist Murray Rothbard defines inflation as "an increase in the money supply not consisting of an increase in the money metal." (America's Great Depression, p.12)

When the money supply is inflated, each unit of currency becomes worth less than it was before the inflation occurred. It may take some time for the market to adjust to this increase in the money supply, but the end result is a currency whose values has been much depreciated. Inflation is the reason why an increase in wage rates is often insufficient to cover the increase to the cost of living.

What Paul is saying is that focusing on prices is entirely the wrong thing to do. Since the money supply has doubled, the currency has already been inflated. We may not want to experience it, but since it's happening presently, it is only a matter of time before the symptoms of inflation--i.e. high prices--set in, which will further hurt the economy.

He continues:

What if we have a situation where prices, which is not the best measure of inflation, but let’s say the consumer price index (CPI) is going up 8% to 10% and there is no economic growth. Where are you then, because that’s not impossible, it’s happened. It’s happened in our history, it happens throughout the world, it’s a common thing, it puts you between a rock and a hard place. If you drain, interest rates go up and the economy further crashes. If you don’t, you have the explosion.

Can you give me an idea what you precisely would do if you face the situation where prices were going up 10% with no economic growth?

A very sensible question. To which Bernanke responds:

Well, I think that’s an unlikely scenario but we certainly would have to take steps to ensure price stability, because if inflation gets out of control we know it has very adverse effects on the economy, both in the medium and long term and so we would obviously have to address that.

The Chairman prides himself as a student of the Great Depression. I'm hoping he realizes that President Hoover also attempted to keep prices stable. Specifically, he insisted that businesses keep wages up--which they did. For those fortunate enough to have jobs, the Great Depression wasn't unbearable; but those forced out of the labor markets when wages were maintained at a much higher rate than the market could support were less lucky. Anyway, outside of outright price controls--which, aside from being an affront to liberty, have deleterious effects--it is difficult to see how the Government will maintain price stability--though I'm not doubtful that they'll try to do so.

Moreover, it is unclear why price stability should be a good thing. We who live with an always inflationary Federal Reserve might react skeptically to such an assertion: of course prices should be kept stable. After all, one couldn't suggest with any seriousness that they should always continue to rise. On the contrary, it would be most desirable if prices, specifically those of consumer goods, fell. And in the free market, this is precisely what happens. As capitalism produces more goods with less labor, the extra goods drive down the cost of that good and provide more people with that good than ever before. Meanwhile, the displaced labor can be allocated to produce goods to meet other market demands, to the betterment of all.

As Rothbard points out, speaking of the economic bubble of the 1920's which led to the Great Depression:

Federal Reserve credit expansion, then, whether so intended or not, managed to keep the price level stable in the face of an increased productivity that would, in a free and unhampered market, have led to falling prices and a spread of increased living standards to everyone in the population. (ibid. p.171)

Of course, now that the money supply has doubled, it's a bit silly to expect prices to fall as they would in a market free from the tangles of the Federal Reserve. Nor is it likely that even prices stability will be achieved. But should Bernanke's "unlikely scenario" become a reality sometime during the coming year or two, we may profit from yet another reminder that current economic policy is as irrational as it is ineffective in achieving its desired ends. Maybe then we'll finally put an end to it.


troutsky said...

In a "free and unhampered market" the lion lay down with the lamb and all the little elves laughed at the Princess' jokes. Such a market would require all actors begin with equal holdings and receive exactly the same information, have the same power and care not a whit for losers. Once we reach full employment we can start to worry about inflation. Till then Ron Paul should concentrate on bringing Texas into the real world.

A Wiser Man Than I said...
This comment has been removed by the author.
A Wiser Man Than I said...

Such a market would require all actors begin with equal holdings and receive exactly the same information, have the same power and care not a whit for losers.I'm not sure I follow. The system I propose depends upon the natural inequalities--of wealth, ability, etc.--which exist in mankind, though it could work fine even with equality.

Once we reach full employment we can start to worry about inflation.Debasing the currency will exacerbate unemployment.Meanwhile, those fortunate enough to retain employment will find it harder and harder to make ends meet.