Money and Inflation: The Tendency to Deny Reality

[alkemical]

Money and Inflation: The Tendency to Deny Reality (http://mises.org/story/2525)

Money and Inflation: The Tendency to Deny Reality
By Frank Shostak
Posted on 3/27/2007
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In a high-profile research paper titled "Understanding the Evolving Inflation Process," published recently, a group of private-sector and academic economists have endorsed the Fed's policy of price stability and transparency as an important tool in keeping inflation at bay.[1]

Economists have however, warned the Fed not to rely too much on inflationary expectations as the main tool for controlling inflation. The writers of the paper maintain that their research shows that inflationary expectations actually don't cause inflation, but that things are the other way around.

The heart of their analysis is a modified Phillips Curve equation, which is labeled the New Keynesian Phillips Curve (NKPC). What drives the inflationary process in this way of thinking is expected inflation, past inflation, the real output gap and some disturbances, i.e., irregular events. In this way of thinking an increase in the output gap — i.e. a relative increase in actual output versus potential output — gives rise to inflationary pressures.

Using the NKPC and two other equations that deal with the output gap and interest rate determination, the researchers have made an attempt to explain the reason behind the great inflation between the mid-1960s and the late 1970s. The economists have also produced an explanation for the fall in the pace of inflation since the early 1980s. The reason for the great inflation, according to the paper, is the lack of willingness on behalf of Fed officials back then to stick to the goal of keeping prices stable. While the reason for moderate inflation since the 1980s, according to these economists, is central bankers commitment to price stability.

Despite the use of sophisticated mathematical and statistical techniques, the research paper never gets to the heart of the phenomenon of inflation. Also, the paper deals with the description of price changes without acknowledging any role that money might have had in these changes. The entire framework is based on a dubious modified Phillips curve and a black-box, time-series analysis. Whilst the research paper mentions extensively the word "inflation," it never even attempts to define this term. The lack of a clear identification of what inflation is all about casts doubt on various conclusions that the writers of this paper have reached. Covering undefined terms with mathematical dressing cannot make the analysis more meaningful if the object of the analysis is not clearly identified.

Defining inflation

The subject matter of inflation is the debasement of money. For instance, historically inflation originated when a ruler would force the citizens to give him all the gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return to the citizens diluted gold coins. On account of the dilution of the gold coins, the ruler could now mint a greater amount of coins for his own use. (He could now divert real resources to himself). In short, what was now passing as a pure gold coin was in fact a diluted gold coin. The expansion in the diluted coins that masquerade as pure gold coins is what inflation is all about. As a result of inflation, the ruler could engage in an exchange of nothing for something.

Under the gold standard, the technique of abusing the medium of the exchange became much more advanced through the issuance of paper money unbacked by gold. Inflation therefore means here an increase in the amount of paper receipts that are not backed by gold yet masquerade as true representatives of money proper, gold. Again the holder of unbacked money can now engage in an exchange of nothing for something.

In the modern world the money proper is no longer gold but rather paper money hence inflation in this case is purely the increase in the stock of paper money. Please note we don't say as monetarists are saying that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

Once it is established that the subject matter of inflation is the expansion of the money stock, we can attempt to ascertain whether the Fed is an inflation fighter.

Monetary inflation and prices

Most economists and commentators define inflation as a general rise in prices, which is summarized by the so-called consumer price index (CPI). While a general rise in prices may be associated with inflation, it is however not inflation. What is the price of a good? It is the amount of money asked per unit of a good. (Observe that without money one cannot even begin to discuss what prices are.)

Now, if for a given stock of goods an increase in the money supply occurs, this would mean that more money is going to be exchanged for a given stock of goods. Obviously then the purchasing power of money is going to fall, i.e., the prices of goods are going to increase (more money per unit of a good). In short, in this case inflation is associated with the general increase in prices.

But now consider the following case: the rate of growth in money is in line with the rate of growth in goods. Consequently, there is no change in prices of goods. Do we have inflation here or don't we?

For most economists, if an increase in the money supply is exactly matched by the increase in the production of goods, then this is fine, since no increase in general prices has taken place and therefore no inflation has emerged. We suggest that this way of thinking is false since inflation has taken place, i.e., the money supply has increased. This increase cannot be undone by the corresponding increase in the production of goods and services.

For instance, once a king has created more diluted gold coins that masquerade as pure gold coins he be able to exchange nothing for something irrespective of the rate of growth of the production of goods. In short, regardless of what the production of goods is doing, the king is now engaging in an exchange of nothing for something, i.e., diverting resources to himself by paying nothing in return. The same logic can be applied to money paper inflation. The exchange of nothing for something that the expansion of money sets in motion cannot be undone by the increase in the production of goods. The increase in money supply — i.e., the increase in inflation — is going to set in motion all the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the production of goods.

For mainstream economists, an increase in economic activity is almost always seen as a trigger for a general rise in prices, which they erroneously label inflation. But why should an increase in the production of goods lead to a general increase in prices? If the money stock stays intact, then we will have here a situation of less money per unit of a good — a fall in prices. This conclusion is not affected even if the so-called economy operates very close to "potential output" (another dubious term used by mainstream economists). Only if the pace of money expansion surpasses the pace of increase in the production of goods will we have a general increase in prices. Note that this increase is only on account of the inflation of money and not on account of the increase in the production of goods.

Another popular explanation for a general rise in prices is the increase in wages once the economy is close to the potential output. If the amount of money remains unchanged then it is not possible to raise all the prices of goods and wages. So again the trigger for a general rise in prices has to be monetary expansion.

Having established that inflation means monetary expansion, we suggest that the key factor behind the acceleration in prices in the period of mid '60s to late '70s is the strong monetary expansion in that period.

In relation to its 12-month moving average, our measure of money AMS followed an exponential path (see chart). For instance, in August 1969 the differential between the AMS and its 12-mma stood at negative 0.5 against positive differential of 21 in December 1979. It is therefore not a big surprise that the gap between the CPI and its 12-month moving average jumped to 4 by December 1979 from 0.9 in August 1969 (see chart).

[alkemical]

In contrast, since 1980 monetary expansion has not been as aggressive relative to its 12-month moving average. In relation to its 12-month moving average, AMS has been trend-less (see chart). So it is not surprising that the CPI in relation to its 12-month moving average has also been trend-less (see chart). The introduction of new technology has probably given a boost to the production of goods, which in turn has contributed to the lowering of the general increase in prices. Another positive is the strong increase in the supply of goods from various economies such as the former Soviet block and China.

Contrary to popular thinking, the Fed's preoccupation with price stability, by keeping the rate increases in the CPI at a particular acceptable range, can actually generate nasty surprises. For instance, as a result of strong monetary expansion and a correspondingly strong increase in the production of goods, prices remain stable. Notwithstanding this stability, various nasty side effects that emanate from monetary expansion are likely to emerge. Hence we suggest that Fed policy makers should pay close attention to the sources of monetary inflation rather than focusing on the symptoms of inflation.

$29
On this Rothbard wrote,
The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the Great Depression caught them completely unaware.[2]

Similarly Mises explained in his essay "Inflation: An Unworkable Fiscal Policy,"

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term "inflation" to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. … As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.[3]

But if the Fed were to acknowledge that inflation is actually printing money, then it would mean that the US central bank is not an inflation fighter but is itself the key source of inflation. After all, without the Fed's monetary expansion, the whole machinery of inflation would have fallen apart.


--------------------------------------------------------------------------------

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. He is chief economist of Man Financial, Australia. Send him mail and see his outstanding Mises.org Daily Articles Archive. Comment on the blog.

Notes

[1] "Understanding the Evolving Inflation Process." US Monetary Policy Forum 2007 by Stephen G. Cechetti, Peter Hooper, Bruce C. Kasman, Kermit L. Schoenholtz and Mark W. Watson.

[2] Murray N. Rothbard. America's Great Depression, Sheed and Ward Inc., 1975, p. 153.

[3] Ludwig von Mises. Transcript of remarks before the Conference on the Economics of Mobilization, held at White Sulphur Springs, West Virginia, April 6–8, 1951, under the sponsorship of the University of Chicago Law School. Reprinted from The Commercial and Financial Chronicle, April 26, 1951.

[alkemical]

Wags (or anyone else) if you got time or effort could you give me a critique? I'd like to get a "competing" economic review of this....

Thanks!

[alkemical]

So is the fed a major factor in actually creating inflation? Anyone? Bueller?

[Bronco Bob]

So is the fed a major factor in actually creating inflation? Anyone? Bueller?

I thought the point of the Fed manipulating interest rates was to prevent
inflation, not to create inflation. Greenspan was especially hard nosed
about keeping inflation down, even when he was being criticised because
some were saying high interest rates were hurting the economy more
than inflation would have.

[alkemical]

I thought the point of the Fed manipulating interest rates was to prevent
inflation, not to create inflation. Greenspan was especially hard nosed
about keeping inflation down, even when he was being criticised because
some were saying high interest rates were hurting the economy more
than inflation would have.

"Similarly Mises explained in his essay "Inflation: An Unworkable Fiscal Policy,"

Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term "inflation" to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation. … As you cannot talk about something that has no name, you cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation, rising prices. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy of increasing the quantity of money that must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.[3]

But if the Fed were to acknowledge that inflation is actually printing money, then it would mean that the US central bank is not an inflation fighter but is itself the key source of inflation. After all, without the Fed's monetary expansion, the whole machinery of inflation would have fallen apart. "

[alkemical]

http://www.fff.org/freedom/fd0612e.asp

Inflation Is Legalized Robbery, Part 1
by Gregory Bresiger, Posted March 23, 2007

Part 1 | Part 2

Inflation. It’s the biggest problem in the world.

— Paul Cabot, legendary money manager quoted
in The Money Masters, by John Train.

A dangerous specter once again haunts our economy, our pocketbooks, and the value of almost every asset.

It is called inflation. And it is hurting us every day. It could also crush the hopes and dreams of millions of Americans engaged in any kind of spending, saving, or investment plans. That’s because our government, charged with curing or at least controlling it, is the source of the problem.

Given a proper understanding of what inflation is — it is the debasement of a fiat currency through the overprinting of money without any stated limits — there is only one party responsible: the government’s banking authority.

Yet few Americans seem to understand the origins of inflation. Others comprehend it but embrace limited or “comfortable inflation” as necessary for attaining a healthy economy. Over the course of centuries some have advocated the use of inflation as a way of redistributing income or as a way of paying for wars.

Inflation has always had an indisputable benefit for the governments playing this game, since few people understand what is happening until the policy has run amuck. Unfortunately, many of the most influential people in our society support a little inflation as a good thing. They argue that it keeps the nation out of depressions and sometimes provides a Robin Hood effect.

[alkemical]

For example, back in 1972, the average American had a weekly paycheck of $334.60, according to the U.S. Labor Department. Today, the average American makes more than that in nominal dollars (dollars that don’t reflect inflation rates). However, corrected for inflation, the average American today makes just $277.96.

[alkemical]

Anyone got a critique for me?

[bendog]

I'm not at all sure we haven't radically increased the money supply in the last 4 years. Bushii has cut back on the info given out. If so, there could be several reasons: 1. We face deflationary pressure from world trade, so we've stimulated inflation. 2. Deficits.

I'm no economist, but the article seemed ok. It didn't really distinguish between Keyensian attempts to stem inflation via price controls and the monetarists who just raised rates so high people stopped buying.

[alkemical]

That's where i get confused as well Bendog.

[alkemical]

The Federal Reserve Monopoly over Money (http://www.house.gov/paul/tst/tst2007/tst040907.htm)


April 9, 2007

Recently I had the opportunity to question Federal Reserve Chairman Ben Bernanke when he appeared before the congressional Joint Economic committee. The topic that morning was the state of the American economy, and many of my colleagues raised questions about how the Fed might better "regulate" things to ease fears of an economic downturn. The tenor of my colleagues' questions suggested that Mr. Bernanke's job is nothing less than to run the U.S. economy, like some kind of Soviet central planner.

Certainly it’s true that Mr. Bernanke can drastically affect the economy at the drop of a hat, simply by making decisions about the money supply and interest rates. But why do members of Congress assume this is good? Why do we accept without objection that a small group of people on the Federal Reserve Board wields so much power over our economic well-being? Is centralized, monopoly control over our money even compatible with a supposedly free-market economy?

Few Americans give much thought to the Federal Reserve System or monetary policy in general. But even as they strive to earn a living, and hopefully save or invest for the future, Congress and the Federal Reserve Bank are working insidiously against them. Day by day, every dollar you have is being devalued.

The greatest threat facing America today is not terrorism, or foreign economic competition, or illegal immigration. The greatest threat facing America today is the disastrous fiscal policies of our own government, marked by shameless deficit spending and Federal Reserve currency devaluation. It is this one-two punch-- Congress spending more than it can tax or borrow, and the Fed printing money to make up the difference-- that threatens to impoverish us by further destroying the value of our dollars.

The Fed’s inflationary policies hurt older people the most. Older people generally rely on fixed incomes from pensions and Social Security, along with their savings. Inflation destroys the buying power of their fixed incomes, while low interest rates reduce any income from savings. So while Fed policies encourage younger people to overborrow because interest rates are so low, they also punish thrifty older people who saved for retirement.

The financial press sometimes criticizes Federal Reserve policy, but the validity of the fiat system itself is never challenged. Both political parties want the Fed to print more money, either to support social spending or military adventurism. Politicians want the printing presses to run faster and create more credit, so that the economy will be healed like magic- or so they believe.

Fiat dollars allow us to live beyond our means, but only for so long. History shows that when the destruction of monetary value becomes rampant, nearly everyone suffers and the economic and political structure becomes unstable. Spendthrift politicians may love a system that generates more and more money for their special interest projects, but the rest of us have good reason to be concerned about our monetary system and the future value of our dollars.

[bendog]

Interesting. And additionally, last year congress changed the formula for soc security colas. In the future they're tied to inflation, while in the past they were tied to wages, which generally rise faster than inflation.

[alkemical]

I didn't know that.....

[bendog]

Well, soc security is sort of solvent again. (-:

I think what's happening is this. 1. Bushii's admin made a concious decision to weaken the dolllar. I talked with a guy with an economics background and his take was that the dollar was unusually high anyway, because mainly the lack of growth in europe and the economic risks in S. America. But, your link is no doubt right. By increasing the money supply, bushii has effectively devalued the dollar. Nixon did the same thing, and it was counterproductive: it ushered in the inflation of the 70s. (LBJ's deficits didn't help either). That was the lesson of the monetarists.

2. Why did bushii do this? Like most things this inept admin has done, they simply don't give many reasons. Perhaps because they're half assed and half thought through. Supposedly it was to help US manufacturing .... ah well, it failed there if that was the reason.

3. We do know that the one thing WJC's economic guys had in common with Bushii's is that they agree that Greenspan could have gotten more gnp growth without inflation. And, even the monetarists don't discount the notion of "throwing money at something stimulates something." That's one reason for the tax cuts. And WJC wasn't against tax cuts, just deficits. But bushii's done one better by generating deficits. That means TBills. Who buys tbills? China and the guys getting bushii's tax cuts!! That's a win-win for bushii. Hell, Neil's working for the Chinese. LOL I mean Hill and Bill were in bed with the chinese, but this is taking it a bit further.

4. But is there inflation? Free trade and oil have changed things since I entered the marketplace back in the recessions of the 70s. Prices for textiles and lawn mowers are really going down. But those are markets that are elastic where demand controls price and supply. Gore's right in that industries, and firms within industries that are more green than competitors (Toyota), will outperform the less green, because the carbon component is not obtained in an elastic market. When I put in auto glass and drove trucks in the 70s, employers were always struggling to keep our wages up with inflation. That's not true now to the same extent. And the NAFTA superhighway goes one better. Goods and non-carbon components can be offloaded in Mexico and driven right to the site where they are sold or consumed in production without an American ever seeing them.

5. The inflation we're beginning to see is from oil prices. IF oil starts to trade on the euro, we're in deeeeeeep. US wages are starting to go up for the first time in the Idiot from Texas's term. The feds griping, and house prices look set to drop maybe 5%.

ps
http://news.yahoo.com/s/ap/20070413/ap_on_bi_go_ec_fi/economy;_ylt=Ak5B2ZFs4BJnq3dDbYYSyWHMWM0F

[alkemical]

Lots of good stuff bendog. I only know very general basics of econ - and have been trying to learn some info. Much appreciated for your time.

[alkemical]

Panama Has No Central Bank (http://www.mises.org/story/2533)


By David Saied

Posted on 4/26/2007
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In this modern, post-–Bretton Woods world of "monetary order" and coordinated central-bank inflation, many who are otherwise sympathetic to the arguments against central banks believe that the elimination of central banking is an unattainable, utopian dream.

For a real-world example of how a system of market-chosen monetary policy would work in the absence of a central bank, one need not look to the past; the example exists in present-day Central America, in the Republic of Panama, a country that has lived without a central bank since its independence, with a very successful and stable macroeconomic environment.

The absence of a central bank in Panama has created a completely market-driven money supply. Panama's market has also chosen the US dollar as its de facto currency. The country must buy or obtain their dollars by producing or exporting real goods or services; it cannot create money out of thin air. In this way, at least, the system is similar to the old gold standard. Annual inflation in the past 20 years has averaged 1% and there have been years with price deflation, as well: 1986, 1989, and 2003.

Panamanian inflation is usually between 1 and 3 points lower than US inflation; it is caused mostly by the Federal Reserve's effect on world prices. This market-driven system has created an extremely stable macroeconomic environment. Panama is the only country in Latin America that has not experienced a financial collapse or a currency crisis since its independence.

As with most countries in the Americas, Panama's currency in the 19th century was based on gold and silver, with a variety of silver coins and gold-based currencies in circulation. The Silver Peso was the currency of choice; however, the US greenback had also been partially in circulation, because of the isthmian railroad — the first railroad to connect the Atlantic to the Pacific — that was built by a US company in 1855. Panama originally became independent from Spain in 1826, but integrated with Colombia; however, being a small state, it was not able to immediately secede from Colombia, as Venezuela and Ecuador had done. In 1886 the Colombian government introduced several decrees forcing the acceptance of government fiat paper notes. Panama's open economy, being based on transport and trade, plainly could not benefit from this; an 1886 editorial of its main newspaper read:

"there is no country on the globe, certainly no commercial center, in which the disastrous consequences of the introduction of an irredeemable currency would be felt as in Panama. Everything we consume here is imported. We have no products and can only send money in exchange for what is imported."

In 1903, the country became independent, supported by the United States because of its interest in building a Canal through Panama. The citizens of the new country, in distrust of the 1886 experiment of forced fiat Colombian paper notes, decided to include article 114 in the 1904 constitution, which reads,

"There will be no forced fiat paper currency in the Republic. Thus, any individual can reject any note that he may deem untrustworthy."

With this article, any currency in circulation would be de facto and market driven. In 1904 the Government of Panama signed a monetary agreement to allow the US dollar to become legal tender. At first, Panamanians did not accept the greenback; they viewed it with mistrust, preferring to utilize the silver peso. Gresham's Law, however, drove the silver coins out of circulation.[1]
In 1971 the government passed a banking law that allowed for a very liberal and open banking system, without any government agency of consolidated banking supervision, and confirmed that no taxes could be exacted from interest or transactions generated in the financial system. The number of banks jumped from 23 in 1970 to 125 in 1983, most of them being international banks. The banking law promoted international lending, and because Panama has a territorial tax system, profits from loans or transactions made offshore are tax free.

This, and the presence of numerous foreign banks, allows for international integration of the system. Unlike other Latin American countries, Panama has no capital controls. Therefore, when international capital floods the system, the banks lend the excess capital offshore, avoiding the common ills, imbalances, and high inflation that other countries face when receiving huge influxes of capital.

Fiscal policy has little room to maneuver since the treasury cannot monetize its deficit. Plus, fiscal policy does not influence the money supply; if the government tries to raise the money supply during a contraction period by obtaining debt in international markets and pumping it into the system, the banks compensate and take the excess money out of circulation by sending it offshore.

Banks cannot coordinate inflation due to ample competition and the fact that (unlike even the United States banking system prior to the Federal Reserve) they do not issue bank notes. The panics and general bank runs that were so common in the US banking system in the 19th century have not occurred in Panama, and bank failures do not spread to other banks. Several banks in trouble have been bought — before any runs ensue — by larger banks, attracted by the profits that can be made from obtaining assets at a discount.

There is no deposit insurance and no lender of last resort, so banks have to act in a responsible manner. Any bad loans will be paid by the stockholders; no one will bail these banks out if they get into trouble.

After several years of accumulation of malinvestments during the booms, banks begin the necessary liquidation of bad credit. Since there is no central bank that can step in to provide cheap credit, the recession begins without any hampering by monetary policy. Banks thus create the necessary contraction by obeying market forces. Panama's recessions commonly create deflation, which mollifies consumers and also facilitates the recovery process by reducing business costs.

Only the fact that the law does not allow for the downward flexibility of wages makes recessions longer than they would otherwise be.

Deflation happens without the terrible consequences that Keynesian economists predict; and the country, now under democratic rule, is experiencing its 4th year of market economic growth well above 7%. So the policy makers who have said that abolition of the central bank is unfeasible need only look to Panama's macroeconomic environment, which has been favorable for over 100 years, to realize that it is, in fact, not only possible, but very beneficial. Clearly no government-forced fiat currency, no central bank, and the absence of high inflation are working quite well in this small country. Who can argue that these policies would not work in larger economies?

David Saied is head of National Public Policy for the Government of Panama and also directs the National Competitiveness Program. Send him mail. Comment on the blog.

Note

[1] Carlos E. Ramirez, Monetary History of Panama, p. 5.

[Bob]

I think you have a one-sided conversation here Mr. Steven Hawking.

Now, if you can explain how inflationary pressures will make it impossible for Al Davis to no longer afford his life preserving medications, I am all ears.