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IT JUST AIN'T SO

Something Besides Money Growth Causes Inflation?

The Root Cause of Inflation Is a Settled Matter for Most Economists

JULY 01, 2007 by HOWARD BAETJER JR.

Howard Baetjer, Jr., is a lecturer in economics at Towson University.

Some economic phenomena can result from a variety of causes. A temporary increase in unemployment, for example, might be caused by a sudden, disruptive change in production technology, or in trade patterns, or in labor or tax laws; or it could be caused by natural disasters or wars, or by recessions due to monetary or fiscal policy. In such cases the exact cause is unclear.

By contrast, a few economic phenomena have one and only one root origin; when we see the effect, we can be sure of the cause. One of these is inflation. Its root cause is a settled matter for most economists. In the words of the great Milton Friedman, whose masterwork with Anna Schwartz, A Monetary History of the United States, did a lot to settle the matter, “Inflation is always and everywhere a monetary phenomenon.”

Unfortunately, many educated commentators have not learned this important truth. One of these is Robert Samuelson, who wrote in the Washington Post (“The Upside of Recession?” April 25) that government subsidies can increase inflation and that recessions can reduce it. But that ain’t so.

To understand Friedman’s aphorism, let us consider this thought experiment: Suppose tonight, as we sleep, Harry Potter flies across the country and waves his magic wand to cast a money-doubling spell. The spell has no effect on the amount of goods and services; it affects only money. Every nickel becomes a dime, every quarter becomes a 50-cent piece, every dollar becomes two, every ten-dollar bill becomes a twenty, every checking account doubles its balance—in short, the money supply doubles overnight. What would we expect to happen to prices over the next day or two?

Even if no one knew that everybody else’s money holdings had also increased, we would expect to see prices rise very fast as sellers discover that they can charge more for their goods than they could yesterday. Picture automobile dealerships. As people perceived an apparent sudden increase in their “wealth”—it’s not wealth, it’s just money, but they don’t know that yet—many of them would head out excitedly to buy a new car. The dealerships would see many more customers than yesterday, all willing to pay much more than yesterday. The dealers would quickly raise their prices, realizing that they can charge more for their cars (which are no more numerous than yesterday). A similar process would occur at every store, market, online retailer, and real-estate agency in the land, and soon the price of just about everything would (to oversimplify a bit) approximately double.

The experiment illustrates the core of Friedman’s insight—the general level of prices is a consequence of the money supply.

Now, would we say that Harry Potter had caused inflation? No, not if we use the term precisely. Inflation is a continuing increase in the level of prices, whereas the money-doubling spell would cause only a one-time doubling of prices. If Harry uses the spell only once, and nothing else increases the money supply, then we should expect prices to stabilize after their one-time jump. (Or, rather, in a healthy and innovative economy in which entrepreneurs continually figure out ways to cut costs and produce ever-greater abundance of goods and services, we should expect prices overall to decrease gradually. After all, with ever-increasing amounts of stuff to buy, and a fixed quantity of money to buy it with, everything should sell for less and less as time passes.)

If Harry Potter wanted to cause inflation—a continuing increase in the level of prices—he would have to cast a money-increase spell and leave it on so that more money would be created every night. Without a continuing increase in the quantity of money, there can be no inflation. This is what Milton Friedman meant by his memorable aphorism.

A consequence of this insight exposes the mistake made by Robert Samuelson and many others. Anything that does not continually increase the money supply can not cause inflation.

So what does cause inflation? Well, what or who increases the money supply? Central banks do. In the United States, the Federal Reserve System (the Fed) controls the money supply and thereby causes any inflation that occurs.

Let us look at some of Samuelson’s specific points. He implies that high oil prices are driving inflation when he writes, “We all know about oil. Prices are about $60 a barrel,” and he asserts that government spending drives inflation when he writes, “[T]he government’s subsidies for corn-based ethanol are worsening inflation.” Samuelson is surely correct that government should not subsidize ethanol and thereby push up the prices of corn and all things made with corn. But high oil prices and government spending on ethanol do not change the money supply, so they cannot change the level of prices.

Surely higher prices for oil and corn drive up the prices of goods and services produced using oil and corn, such as transportation and many foods, so we should expect to see higher price levels in those sectors of the economy. But inflation is an increase in the prices overall, not in just some sectors. If the prices of transportation and food rise, then the prices of other goods and services must fall unless more money flows into the system. If we have no more to spend in toto, then when we must spend more money on gasoline, we have less money to spend on, say, clothing. This means that clothing makers would have to lower their prices in order to sell their wares; they in turn would have less to spend on cloth, labor, and other inputs, so we should expect to see lower price levels in those sectors of the economy. The higher prices in one sector would be offset by lower prices in other sectors, as long as there is only so much money to go around.

 

Anti-inflationary Recessions?

Samuelson also says that “downturns check inflation.” But that ain’t so either, at least not when we consider what happens after the recession. He says, plausibly, that “it’s harder to increase wages and prices” in a downturn. While this may be true during the downturn, if the money supply is increasing unabated—so that eventually prices and wages will have to adjust to the larger money supply—people’s hesitancy to raise wages and prices during the downturn simply creates a lag. Prices and wages will have to catch up later.

In practice, causation will more frequently run the other way, with inflation today causing a downturn later. As Steven Horwitz and others have explained, inflation not only increases the level of prices, it also distorts relative prices, the economy’s essential means of communicating the relative scarcity of various goods, and thereby interferes with economic coordination. (See Horwitz’s Microfoundations and Macroeconomics: An Austrian Perspective.) That interference can itself cause or prolong recessions. The longest period of poor economic performance in my lifetime was the 1970s, a period of inflationary recession. Not only did the long, deep downturns of that decade not “check inflation,” on the contrary the inflation likely deepened the downturns.

Friedman’s maxim bears frequent repeating. Who controls the money supply controls inflation. As for any claim to the contrary, it just ain’t so.

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July/August 2007

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