Thursday, January 10, 2008

Understanding Inflation and Deflation

In order to discuss monetary issues, we have to be precise about our definitions of inflation and deflation. This is one of the most confusing issues and it took me a year to really understand this. The problem is that these terms are thrown around to mean different things depending on what school of economics one is using.

The Austrian definition of inflation is an increase in the money supply. Deflation is a decrease in the money supply. Keynesian economists changed the meanings of the terms. They defined inflation as an increase in the prices of goods and deflation as a decrease in the prices of goods.

To differentiate between the two, I will use the terms monetary inflation and monetary deflation to refer to the Austrian terms. I will use the terms price inflation and price deflation to refer to the Keynesian terms.

The Keynesian concept of price inflation is not well defined. If the price of goods rise, is it because the amount of money has increased, is it because the demand for the goods increased, or is it because the supply of the goods decreased? With price inflation, we have headline inflation and core inflation (excludes food and energy). We have the pre-Clinton era basket of goods methodology, we have the current methodology, and we have the new experimental methodology. Who gets to decide what's in the basket of goods? If the price of pork goes up because there was a pig disease that wiped out half the pigs, should the Fed raise interest rates? If the price of corn goes up because we're burning it in our cars, is this something the Federal Reserve should account for. Then we have the consumer price index and the producer price index which figure into monetary policy. This is the conflict between Austrian and Keynesian economics. It mixes monetary policy with the normal fluctuations in goods caused by changes in supply and demand in the market. The Keynesians are forever changing their models because the fundamental assumptions make no sense. In fact, in the 1970's something happened that Keynesian economics predicted was impossible: we had a recession but prices kept increasing. They had to invent a new term for this phenomena, stagflation. There is no such concept in Austrian economics because the money supply is either increasing or decreasing and the prices of goods are set by the market clearing price based on supply and demand.

Even if one believes the Federal Reserve is not a system designed for the benefit of bankers, politicians, and special interest as I believe it is, it still is fundamentally flawed. The Federal Reserve is the dog chasing its own tail. It continuously tries to adjust monetary policy to make us all wealthy, but monetary policy can't make us wealthy. The Federal Reserve controls money. That can't make us wealthy because money isn't wealth. It's simply a mechanism for moving wealth around so that we don't need to use the barter system. The Federal Reserve can print and destroy money, but this doesn't give us the things we need. When the Federal Reserve has a machine that can print food, clothing, houses, and energy, it will be able to make us all wealthy.

The Federal Reserve tries to accomplish impossible goals with monetary policy. It must create enough monetary inflation at a fast enough rate so that Congress can forever spend more money than it takes in. This lets the government pay interest with future dollars that are less valuable. Although this isn't part of the Fed's mandate, the government would literally default if the Fed didn't make this possible. It then has two statutory mandates. It has to keep price inflation low so that consumer goods don't rise in price too fast. The first two goals are at odds with each other. Since monetary inflation eventually results in price inflation, the government has to keep changing the model for calculating price inflation to show that it's low. Also, when prices go up for a reason that has nothing to do with monetary policy (e.g. a drought or an energy crisis), the Fed has to raise interest rates to counteract it. Finally, the Fed is expected to keep the economy growing (i.e. jobs). This is in conflict with the first two goals. Luckily, the Fed doesn't really care what type of jobs are being created so it's okay if desirable factory jobs are replaced with service jobs at Walmart. To accomplish all this, the Fed tries to influence the market by changing interest rates, but the market moves very quickly and interest rate changes can take a year to filter through the economy to change its course. When the Fed gets it wrong, we get bubbles and recessions.

In the Austrian model. inflation is an increase in money and deflation is a decrease. It's fairly easy to measure. Especially when you use gold as money because you just add the amount mined (very little - ~1% annually these days) and subtract the amount consumed (practically nil). So there's no problems with overestimating it or underestimating it.

So why are are there two different models for defining inflation and deflation? The reason is fairly straightforward. Before the Federal Reserve, inflation always referred to the money supply. I mentioned that the Federal Reserve had a dual mandate: low inflation and economic growth. But the Federal Reserve Act didn't define what inflation was. How convenient! You can't print money or extend too much credit if inflation is defined as money and credit. But if you redefine inflation to mean prices, you can print all the money you want as long as prices stay low. And who decides how to measure whether prices are staying low? The government of course. So the government justifies the printing of money by changing the metric to something that they can control. But does anybody really believe they managed to keep price inflation low?

In 1918, 1 oz of Hershey chocolate cost 3 cents. In 2003, it costs 52 cents. That's almost a 95% loss of purchasing power. If anything it should have gone down in price because we became more efficient at growing the ingredients and manufacturing it. So 95% is probably giving the Fed the benefit of the doubt. The funniest part is that the Fed is always "fighting inflation". They've managed to frame the topic in such a way that they are fighting something that they themselves create. It's pretty brilliant from a marketting point of view. Not so funny though if you're trying to save money for your retirement.

2 comments:

Michael said...

I will hopefully have time to write more later, but for now:

I don't care how much an ounce of chocolate costs in dollars and cents. All I care about is how much chocolate my salary can buy.

You seem to think that price inflation is inherently bad, but the world doesn't seem to work that way. Prices have been going up since 1913, but so have wages. It seems to me that the ratio between the two and how to measure it is the important thing. My dollar buys less chocolate, but my salary buys more chocolate than I could ever hope to eat.

Your argument seems to be that it's very, very difficult to measure price inflation, so we should just get rid of it by fixing the money supply. But getting rid of monetary inflation won't solve the problem. You'll still have price deflation in a fixed monetary environment, and how much deflation is due to economic gains vs. pig disease and how to measure that price deflation will still be an open question.

We will always need some measure of how well our economy is doing and how much purchasing power (a.k.a. wealth) people have. Fixing the money supply might bring a halt to price inflation, but answering that question will still be difficult.

rsdio said...

Michael, I don't think the article ever claims that removing monetary inflation would solve all economic problems. The point is to be able to talk about what's really happening without distracting terminology that misleads the public. In other words, the article does not claim that the whole problem is merely inflation itself, but that the problem is the way we talk about it. To a degree, monetary inflation is a problem, but not the entire problem.

Regarding wage increases offsetting price increases, this just makes it more difficult to determine whether you're getting behind. When both are climbing, banks make money because they're at the input side of the funnel, and workers get the short end of the deal. If we did restrict the government to a steady monetary supply, we'd be better able to gauge the value of our wage increases.