Freeman

FEATURE

Wrapping an Enigma in a Mystery: Why Inflation Is So Misunderstood

OCTOBER 31, 2012 by RICHARD W. FULMER

In his book The Economic Consequences of the Peace, John Maynard Keynes observed, “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”

Inflation—the process by which currency is debauched—is difficult to diagnose largely because it is carefully protected by an army of lies, many promoted by Keynes himself.  Keeping the concept mysterious allows government to debauch its currency without citizens understanding that they are being systematically robbed.

In his General Theory of Employment, Interest, and Money, Keynes made clear that he understood the deception behind inflation as policy: “Unemployment develops, that is to say, because people want the moon; —men cannot be employed when the object of desire (i.e. money) is something which cannot be produced and the demand for which cannot be readily choked off.  There is no remedy but to persuade the public that green cheese [fiat money] is practically the same thing as the moon and to have a green cheese factory (i.e., a central bank) under public control.”

Prices and Money

Perhaps the most effective bit of misinformation was to redefine inflation as a rise in the general level of prices of goods and services.  A general rise in prices, however, is a potential symptom of inflation and not inflation itself—potential because even though a currency is being inflated, prices may not necessarily rise.

Inflation is nothing more than an increase in the amount of money in circulation relative to demand.  If the number of dollars in the market outstrips demand and increases relative to the amount of available goods and services, the dollar’s value will fall and prices will rise.  However, during the 1920s, even though the quantity of money increased nearly 60 percent, prices were fairly stable because productivity rose significantly during the same period, leaving the dollar-to-goods ratio relatively unchanged.

In today’s bout with inflation some prices have risen (food and petroleum) while others have fallen (computers and iPods), but prices have not yet “generally” risen in proportion to the increase in the nation’s money supply.  In part this is because much of the new money is sitting in banks and Federal Reserve accounts (for which the Fed pays interest) and is not in circulation, thanks to the federal government’s anti-growth regulatory, spending, and tax policies.

Another myth is that rising wages or oil prices cause inflation.  On the surface this seems logical.  After all, energy and labor are incorporated into all goods and services, so if their prices rise, the prices of all goods and services must rise as well, right?  No.

If there are a fixed number of dollars and the price of oil goes up, people will either purchase less gasoline or less of something else.  Perhaps they will walk or ride bicycles more or will carpool or cut down on discretionary travel.  Or maybe they will cut back on expenses by eating at home more often or purchasing less popcorn at movie theaters.  If wages go up, companies may increase automation or simply make do with fewer workers.  Higher oil and labor prices, then, will not cause a general rise in prices.  Rather, other prices will fall as fewer dollars are spent on widgets and more on gasoline and labor.

The Myth of Managed Inflation

The country’s current financial woes explode yet another myth about inflation: the idea that a managed, low rate of inflation is sustainable.  The problem is that new money is not initially spread throughout the economy evenly, keeping the market’s complex web of relative prices intact.  Instead, it enters the market at specific points.  Because the Federal Reserve usually inflates the currency by easing credit, the new money tends to flow to things such as homes and cars that are sensitive to interest rates.  In response, capital and labor shift into the construction and auto industries.  When the Fed shuts off the spigot, though, demand collapses and carpenters and auto workers are laid off.  The economy will not fully recover until the capital and labor that were malinvested in home building and auto manufacturing are re-employed in more sustainable areas.

Keynes believed that one of the main barriers to re-employment following a bust was “sticky” wages.  Rising unemployment may indicate that wages are generallytoo high and must fall before more people will be hired. The problem is that workers and unions fight wage decreases and companies tend to resist them as well because of their impact on employee morale.  Keynes argued that by inflating the currency, nominal wages could remain high, while real wages (purchasing power) would drop, making labor cheaper.  For this to work, however, labor had to be kept in the dark—possibly explaining Keynes’s efforts at obfuscation.  As soon as workers caught on to the scam, they would demand cost-of-living increases and the jig would be up. This is exactly what has happened: COLA means more than just a fizzy drink to a large swathe of workers, having long since become a standard feature of most employment contracts.

There are other difficulties with this shell game, though.  First, aggregating all workers into a homogeneous pot called “labor” is inherently problematic.  If the unemployment rate rises, some wages may indeed be too high.  Yet even despite today’s high unemployment rates, there are tens of thousands of job openings for engineers, accountants, welders, and machinists throughout the United States.  The problem is a mismatch between the skills needed and the skills available, and this disparity cannot be remedied by manipulating the currency.  Moreover, currency manipulation ultimately impacts the entire economy; it cannot be narrowly focused on just those sectors in which wages are too high.

Even though Keynesians tend to dismiss the Austrian argument that inflation does not initially raise prices uniformly, the Keynesian “sticky wage cure” depends on new money flowing precisely enough to drop the real wage where wages were too high while keeping it the same (though nominally increasing it) where wages were okay before. The cure requires that new money injected into the economy must impact prices with a selectivity bordering on the magical.  Prices that companies can charge for their products must rise while costs, including labor costs, must remain unaffected. (If a company’s costs were to rise while the prices it could charge remained the same, it could hardly be expected to expand production and hire additional employees.)  Nothing magical happens because one company’s prices are another’s costs.

By contrast, Austrians believe that new money will lead not to a general rise in employment, but to a shift in employment from some sectors of the economy to others.  Further, they argue that this shift will be sustained only so long as the new money continues to flow.  When the money stops, the bubble will burst and the malinvestments caused by the monetary manipulation will be exposed.

Green cheese is no more the moon than fiat dollars are real savings.  Were it otherwise, Zimbabwe, whose monthly inflation rate reached nearly 80 billion percent in 2008, would have wealth piled from here to the Sea of Tranquility.


Filed Under : Federal Reserve, Inflation

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November 2012

ABOUT

RICHARD W. FULMER

Richard Fulmer is a freelance writer from Humble, Texas, and the winner of the third annual Beth A. Hoffman Memorial Prize for Economic Writing for his article "Cavemen and Middlemen," from the April 2012 Freeman

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