So Much Wrong About Inflation

Austrians are more and more noticed in the mainstream.  You don’t get much more mainstream than Paul Krugman; he has written a short blog post (HT EPJ) critical of Austrians and their supposedly creative use of the term “inflation.”  Referencing a Noah Smith post, Krugman writes:

Noah Smith has a funny piece on the hermetic system that is Austrian economics, with its multilayered defenses against any kind of criticism. What gets me in particular, because I’ve noticed it a lot lately, is this:

3. “Inflation” doesn’t mean “a rise in the general level of consumer prices,” it means “an increase in the monetary base”, so QE is inflation by definition.

So when Austrians were predicting runaway inflation, they didn’t actually mean consumer prices?

Insisting that the term “inflation” means something else in your private language is just pathetic.

… [Austrians] could have called a general rise in the CPI a banana. Were they predicting a banana? Of course they were. And they were wrong.

In order to avoid confusion through the remainder of this post, I will use the following definitions (to which Krugman will disagree, but I expect to be proven correct):

Banana = price inflation

Inflation = an increase in the monetary base

To the extent some Austrians and others have predicted runaway- and even hyper-banana to occur, so far they have been wrong.  One might debate the actual increase in consumer prices, but runaway or hyper-banana would be overtly noticed via protests on the street.  No such protests have materialized.

A Dose of Reality (Yes, Krugman is Pathetically Wrong…Again)

What of Krugman’s charge (and he goes somewhat beyond Smith in this) that Austrians have invented the definition of inflation out of whole cloth?  It took me all of one minute to find a source that Krugman could not so easily disparage, The Federal Reserve Bank of Cleveland: On the Origin and Evolution of the Word Inflation, by Michael F. Bryan. 

Unlike Krugman, Bryan actually considers history:

Inflation is the process of making addition to currencies not based on a commensurate increase in the production of goods.

Federal Reserve Bulletin (1919)

This idea of “a commensurate increase in the production of goods” can be found in the original Federal Reserve Act, regarding the discounting of commercial paper:

Upon the indorsement of any of its member banks, with a waiver of demand, notice and protest by such bank, any Federal reserve bank may discount notes, drafts, and bills of exchange arising out of actual commercial transactions; that is, notes, drafts, and bills of exchange issued or drawn for agricultural, industrial, or commercial purposes…. (P. 263, emphasis added)

Inflation was a term used to describe the relationship of currencies to goods – something backing the currency; it had nothing to do with prices.  Just ask the Cleveland Fed and Bryan:

For many years, the word inflation was not a statement about prices but a condition of paper money – a specific description of a monetary policy.  Today, inflation is synonymous with a rise in prices, and its connection to money is often overlooked.

Certainly overlooked by Krugman.

This Economic Commentary considers the origin and uses of the word inflation and argues that its definition was a casualty in the theoretical battle over the connection between money growth and the general price level.  What was once a word that described a monetary cause now describes a price outcome.  

It was a purposeful casualty – macro-economists don’t want you to look at the cause; they only want to direct your gaze to the effect of their choosing.

Bryan offers some history; apparently the term “inflation” (in its original sense) began to gain traction about two centuries ago:

The era between the mid-1830s and the Civil War – a period economists refer to as the “free banking era” – saw a proliferation of banks.  Along with these institutions came “bank notes,” a private paper currency redeemable for a specific amount of metal. That is, if the issuing bank had it.  At times, banks did not have enough gold or silver to satisfy all of their claims.  Bank notes, like the public notes that preceded them, also tended to depreciate.  It is during this period that the word inflation begins to emerge in the literature, not in reference to something that happens to prices, but as something that happens to a paper currency.

This shift in meaning has complicated the position of anti-inflation advocates.

The “shift in meaning” began to take form in the early part of the 20^th century – shortly after the passing of the Federal Reserve Act (surprise, surprise):

Many current controversies about inflation are due not to conflicting ideas but to conflicting uses of the same word.  When a nation has too much money, it is said to have inflation: that is about as near as we can come to an accepted definition of the term.  As to what constitutes having too much money, there is not agreement ... If we use the term inflation to denote any increase in the volume of money that is accompanied by a rise in the general price-level, we confine ourselves to a definite and logical use of the term, and one that directs attention at once to the practical monetary problem with which business is to-day chiefly concerned.

William Trufant Foster and Waddill Catchings (1923) (emphasis added)

This is certainly the definition with which business (and the business of government) would like the rest of us to be “chiefly concerned.”  It allows for all sorts of far more significant harm to occur – harm to most of us, benefit to the politically connected.

Additionally, Bryan offers two quotes by Edwin Walter Kemmerer, one in 1918 and the second in 1934, where the definitional shift has occurred even within the same mind!

You won’t be surprised to learn what delivered the coup de grâce (answer in italics):

In addition to separating the price level from the money stock, the Keynesian revolution in economics appears to have separated the word inflation from a condition of money and redefined it as a description of prices.

This is the crux of the issue; the meaning of the term has changed (no longer meaning “inflation,” but now “banana”), and I would suggest changed purposefully in order to hide the far more significant effects and damages of inflation.

So, as far as Krugman is concerned, suffice it to say he is wrong.

Who cares?  Well, besides a few Austrians being wrongly disparaged….

What of inflation?  What of the shift in definition, to “banana”?  I have suggested before, and will expand here: general price increases are one possible (possible, not certain) effect – but not the only and not the worst effect – of inflation.  There are other, certain effects – certain, and more damaging.

That inflation has come to mean general price increases is nothing more than a high stakes shell game – the public is tricked into watching the wrong walnut shell, all-the-while the more damaging effects (to the general public) of inflation are occurring under the other shells.

Wealth Transfer: From the Rest of Us to the Connected

An advanced, division-of-labor, economy is not possible without money.  As Krugman has introduced a new term “banana,” I will introduce my own term: I will call this money “chits.” 

Place all of the goods available in the world on one side of the room (please, just play along).  Place all of the chits on the other side. 

Most people have to work (meaning: satisfy consumers) to earn the chits. 

However, some people have a chit-making machine; they don’t have to work for the chit, they can merely print chits (today, the digital equivalent).  These chit-makers bestow their favor on a handful of others – those with direct (or first) access to this chit-making machine: government employees, bankers, macro-economists, beneficiaries of government contracts, beneficiaries of government programs, etc.  They can receive the chits not from satisfying the desires of consumers, but by securing favor from the chit-maker.

Even if this largesse does not result in a general price increase (for example, due to being offset by productivity – and more on this shortly), it does result in the transfer to the connected of the ability to secure a larger portion of the goods produced, to the detriment of those who earned their chits via satisfying consumers.  More for them, less for us.

Overly Encouraging Risky and Uneconomic Behavior

Governments and banks are the two primary and largest recipients of this chit-making largesse.  Regarding the first, the relative growth of government since the world-wide adoption of chit-making (and especially since the removal in 1971 of the last connection to any means of discipline) is undeniable.  Regarding the latter, for what industry was the term “too big to fail” coined?

When you have the insurance policy afforded by a chit-making machine at your disposal, do you believe disciplined business practices will result?  To ask the question is to answer it. 

“Well, so what if a few people take more chances than they should?  They will get theirs in the end.”

Don’t be so sure….

Subsidizing Failed Enterprises

One need look no further back than 2008.  An entire industry – the one closest to the chit-making machine – was built on a certain-to-fail business model.  Six years ago, the model failed – unequivocally failed.  Every major bank would certainly have faced insolvency if not for intervention by central banks and their chit-making machine.

Supporters of the chit-makers point to this lender-of-last-resort capability as the prime benefit of having a chit-maker.  “Imagine the catastrophe that would have befallen the world if the banks went bankrupt,” they exclaim. 

Would it have been the end of the world?  Not according to David Stockman.  And – while I have not studied the topic anywhere near the extent that he has – it seems to me that the only result would have been a reorganizing of who owned the assets, exactly as happens with every insolvency. Not painless (especially to the seven- and eight-figure-per-year bankers), but not catastrophic.

Did I forget to mention General Motors?  Recent news only adds to the overwhelming evidence that this is a company that well-deserved to go through the cleansing of a normal bankruptcy procedure.

And what of government?  I will suggest that governments would not be able to borrow so freely absent this chit-making backstop.

Now, you might say this is just mean – “what harm is done to the rest of us if others are allowed to continue in their efforts despite having fallen on hard times?”  To answer this fully is far beyond the scope of this post; suffice it to say that the system of profit and loss coupled with a free-market price regime ensures that consumer demands are being met in the most efficient manner possible.  This efficiency results in a higher general standard of living than would otherwise occur.

Favoring Borrowers, Disadvantaging Savers

The purpose in life of chit-makers is to make credit available, and the tendency is to make it available at terms more generous than the markets would allow at any given time.  This isn’t always and everywhere true, but it is far more often true than not – else why have the chit-maker in the first place?  Do governments and bankers (those who control the chit-maker) desire to borrow at rates higher than the market allows?  Again, to ask the question is to answer it.

Well, just as two plus two equals four, the favorable cost of borrowing results in the unfavorable return to saving.

Again, you might ask “So what?  Borrowing encourages economic activity; savings keeps chits from circulating, thus discouraging economic activity – why are you against economic activity?”

Setting aside this twisted vision of “economic activity,” consider the roots of productivity.  Having considered this, consider how this would be possible absent saving.  Now, having gone through these simple steps, consider what life might be like without savings.

As to the borrowers?  As borrowing is subsidized, more borrowing is done than would otherwise be the case (the boom) – thereby pulling forward consumption.  Consuming more has never been a path to wealth – at least not by any definition I can comprehend.  This subsidized borrowing is also the necessary pre-condition for the inevitable bust.

True savings is the root of future productivity; productivity is what keeps us away from subsistence farming and improves our standard of living.  As this is so, why would savings be discouraged to the advantage of current consumption?

Eliminating the Price Benefits of Productivity

Over the last thirty years, productivity tools have been developed that rival, and perhaps surpass, any similar experience in recorded history.  I would place these in two general groups: technology and telecommunications, and the access to ever-increasing sources of low-cost labor (which can be alternately viewed as a significant increase in the global division-of-labor economy).

The first group: the means to communicate, the efficiencies available to back-office operations, the benefits to the factory floor – all based on the advancements in computing and telephone technology – far overwhelm any similar step-function advancement in the past; I would suggest even more beneficial than what occurred during the industrial revolution.

The second group: China, Mexico, and Eastern Europe.  All three regions brought into the global division-of-labor economy, and at wage rates substantially below those of the developed world.  Those in the developed world have enjoyed (or should have enjoyed) greatly reduced pricing from this shift.

Either event by itself would be sufficient to produce a general reduction in the price level.  Both combined likely could have made this reduction significant.  “So, what happened?” you ask.  “Consumer prices have slowly increased throughout this period.  Where has all the productivity gone?”

As Krugman would say, “Yes, we have no bananas.”  There is little price inflation in the last thirty years.

I suggest that the price inflation has been hidden – buried – by this avalanche of productivity.  The chit-maker’s favored clients have absorbed the benefit (the benefit that should have been available to all of those in the developed world) of the productivity. 

Conclusion

I offer two:

Krugman is wrong. 

Inflation is harmful in ways far more destructive than a generally increasing price level.