Roots of Inflation

On 21 July 2009, Chairman of the Federal Reserve Ben Bernanke defended himself from Ron Paul’s accusations of promoting inflation by defining inflation as an increase in the consumer price index.  Through this definition, Bernanke purported to refute Ron Paul’s own definition—Austrian definition—that inflation referred to an increase in the money supply.  In Bernanke’s defense, according to “mainstream economics” he is correct.  But, Ron Paul’s vindication is that mainstream economists look only at a symptom and not at what causes said symptom.  Ron Paul’s definition of inflation is, in fact, the most accurate definition of the word.  An increase in the money supply causes an increase in the average price level (statistically manifested through the consumer price index).  The lack of understanding of the causes for price inflation is what has led to faulty macroeconomic monetary policies by international governments—specifically, the creation of central banks.  The misconception of what inflation is should be corrected if there is any hope to successfully argue against the supply of artificially created credit.

The mainstream definition of inflation is as follows:

Inflation is an increase in the price level and is usually measured on an annual basis.  The inflation rate is the positive percentage change in the price level on an annual basis.  For example, the inflation rate for 2000 is the percentage change in prices from the end of December 1999 through the end of December 2000… the CPI in December 1999 was 168.9, and the CPI in December 2000 was 174.6.  This means the inflation rate in 2000 was approximately 3.4 percent. (Arnold, Macroeconomics, 2008. p. 117)

Bob Bernanke successfully defined inflation as mainstream economists would define it.  It is puzzling, though, that nobody asks themselves: what causes this increase in the price level? Why do prices increase over time?  The Austrian answer is that increases in the money supply necessarily create a surplus in money (relative to the existing stock of money prior to the expansion).  This theory can be tested mathematically.  Take the supply and demand graph to the left.  A change in demand suggests a shift of the demand curve.  A rightwards shift of the demand curve (represented by the movement between the original curve, or AD₁, and AD₂) can come about through a number of factors: increase in income, change in preference, price of related goods, expectations of future prices and number of buyers.  In this case, the most relevant factor is the increase in income.  This does not suggest an increase in income of the average worker—at least, immediately.  When the Federal Reserve buys a bond on the open market it creates an account for the seller.  Let us say that this account was for a bank, which increases the bank’s reserves.  This leads to a decrease in the lending interest rate, propelling an investor to take out a loan and invest.  Because the Federal Reserve does this on a large scale, it floods the market with credit (a form of money).  The sudden availability of more money can be considered a rise in income.  As investors can better afford capital-goods, the price of these capital-goods increase, because people are willing to pay for the higher prices (there is more money available).  Thus comes the increase in the general price level.

Although Keynesians and Monetarists do, to a degree, agree that increases in the money supply can cause inflation, they do not agree that this is a major factor.  There are three major Keynesian reasons for increases in the price level: demand-pull, cost-push and built-in inflation.  None of these hold water.

Demand-pull inflation is caused by an increase in aggregate demand as compared to aggregate supply.  Since price inflation is normally tied in with economic growth, it is considered that demand-pull inflation is natural in a growing economy.  The idea is that as wealth increases, the proprietors of that wealth have more to spend, raising prices.  There are a couple of fallacies present in this theory.  First of all, wealth (or capital) is not synonymous to money.  Money, or what people use to ease barter (a common tool for transaction), represents each individual’s capital worth (or wealth).  When an economy grows the money supply is not naturally expanded, only capital (capital can be represented, for example, by goods or services).  Logically, in that case it would make sense that money increased in value, not decreased, because the same amount of money would be representing a greater amount of capital.

Second of all, economic growth does not come through an increase in aggregate demand for consumer-goods.  In fact, healthy economic growth is a product of increased savings.  An increase in savings, or an increase in loanable funds, translates into lower interest rates.  These send a signal to entrepreneurs to invest.  Because consumers are saving they are necessarily avoiding present consumption, and so aggregate demand for consumer goods shifts to the left.  This creates a decrease in the price level.  As entrepreneurs invest, there will be a period of time where consumers decide that they no longer want to save as much, as they want to buy goods, and so this sends a signal to entrepreneurs to cut short investment and instead produce lower-order goods—or consumer-goods.  This sudden increase in supply will create a further decrease in the price level.  For an explanation of what causes economic growth see Jesús Huerta de Soto’s Money, Bank Credit and Economic Cycles.  For an example of a period of economic growth with price deflation see Milton Friedman’s and Anna Schwartz’ A Monetary History of the United States 1867–1960.

The second Keynesian theory for inflation, or cost-push, suggests that supply shocks—or sudden decreases in supply—can cause prices to spike.  A typical example of this was the supply shock of petroleum in the 1970s.  The logic behind the theory is sound.  The problem is the premise.  Keynesians believe that these supply shocks can come naturally.  Of course, a natural disaster in some area of the world can cause a major decrease in the supply of a certain good to be found there.  However, macroeconomic theory teaches that in the even of spiked prices consumers will opt for cheaper substitutes.  For example, let us assume that the Pepsi factory is hit by a tornado, severely restricting the supply of Pepsi.  In the face of higher prices for Pepsi, the consumer will shift demand for Coke.  The same is true for goods of the same type, like oil.  In a free market, an increase in the price of petroleum sold by Venezuela would cause a shift in demand for petroleum supplied by another companies.  So, what happens when oil producers monopolize and collaborate to raise prices?  This is what happened during the 1970s, when the OPEC oil cartel cut supply and raised prices.  Upon closer inspection one can see that possible alternatives were smothered by government regulation.  Specifically, local petroleum production was disallowed.  Had there been no regulation oil prices would have fallen dramatically.

Government regulation on oil has existed since Standard Oil was penalized for “harmful competition” (providing lower cost oil to the market).  This would lead to a government-formed cartel in the United States, designed to set prices for the war effort during the First World War, to limit the costs to the government.  Thomas DiLorenzo, in How Capitalism Saved America, explains the history:

After the war they supported President Calvin Coolidge’s Federal Oil Conservation Board, which mandated reduction of oil supplies within the states.  Such a tactic would have been illegal under the antitrust laws if done privately, but since government exempts itself from antitrust laws (and many others), such blatant price-fixing schemes are legal…

Then, in the 1950s, import quotas were imposed.  Thus, by 1960 the industry was fully cartelized, with the government acting as cartel enforcer…

In the early 1970s, [OPEC] imposed an embargo—that is, a sharp reduction in supply.  At the same time, the U.S. government’s barrage of environmental regulations had sharply reduced the domestic supply of petroleum and petroleum products.  For example, the vast reserves of oil on the outer continental shelf off the coast of California were put off-limits to drilling for ear of oil spills that would despoil the coastline… Meanwhile, the hundreds of new regulations that had been imposed on oil refineries made it much more costly, if not unprofitable altogether, to build them.

It was in this climate that the “energy crisis” developed.  OPEC was not the only group responsible for the reduction in the oil supply; America’s own government had done the same by overregulating the industry.  On top of all of this, in 1971 the Nixon administration had imposed wage and price controls in a failed attempt to control inflation—or at least pretend to be controlling inflation just before the 1972 election.  The controls were always intended to be temporary, and they were lifted in 1974 on all products except petroleum.

Cost-push inflation can only exist under the condition that the government restrict the supply of a good.  Otherwise, cost-push price inflation is impossible, since businesses aim at selling their goods and services to as many people as possible.  For example, automobiles were originally luxury items, but can now be afforded by the majority of consumers.  The deal is the same with televisions, microwaves, refrigerators, et cetera.  Even if one supplier was to reduce supply, this would not translate into a decrease in aggregate supply.  Aggregate supply can only be reduced through monopolization of a product, and monopolization can only come through the powers of government.  Never in history has there been a company that has monopolized a product and increased prices.  In fact, those companies shut down by anti-trust laws were trialed when they were offering their goods for much cheaper than the competition.  In a free market, cost-push is a non-issue.

The third Keynesian reason for inflation, or built-in inflation, refers to this supposed push for an increase in wages in expectations of higher prices.  But, there is no reason why companies would accept a demand for an increase in wages without there being an increase in productivity.  Labor unions can cause an increase in wages through government coercion of the industry in question, but in the long-run this will lead to the collapse of the company.  Furthermore, as proved during the Great Depression, an increase in the cost of production (because labor is more expensive) does not cause an increase in the cost of the good.  Otherwise, wages could be increased indefinitely and manufacturers would not profit, or would be able to higher as many workers as possible.  But, the manufacturer cannot set prices above market value.  If the cost to produce is greater than what the manufacturer can sell the product for ultimately the manufacturer is taking a loss.  As a result, built-in inflation is not a viable cause for increases in the price level.

The only logical explanation of a general increase in the price level is an increase in the money supply, as previously explained.  All other explanations are faulty and inaccurate and do not reflect macroeconomic realities.  Otherwise, they are products of government regulation, and not the free market.  Indeed, in a free market it is much more likely that there would be a general decrease in the price level, with periodic decreases in present demand and future supply of goods.  The fact that despite a dramatic increase in the money supply since 2007 has not led to an equally as dramatic increase in the price level, however, seems to undermine the theory.  There are a couple of things to remember.  First, inflation is not seen immediately.  Money poured into the economy will trickle through in stages, eventually increasing the price of capital-goods and ultimately increasing the consumer price index when the increase in the cost of capital-goods leads to an increase in the cost of consumer goods, and ultimately worker’s wages.  So, we have not necessarily had enough time to feel the true inflationary effects of Bernanke’s massive credit expansion.  Second, there is a lot of deflationary pressure on prices, and so credit expansion tends to fight this deflation, or “stabilize” prices, which is an effect which we have been seeing so far.

Chairman of the Federal Reserve Ben Bernanke accurately defined inflation using a textbook definition, but failed to realize Ron Paul’s accuracy in defining the reasons for the increases in the consumer price index.  This lack of understanding of the relationship between the money supply and the price level is what will ultimately lead to dramatic increase in the price level in the United States, if the Federal Reserve is left unchecked.  If the Federal Reserve continues to expand credit at an exponential rate, the U.S. dollar runs the serious risk of hyperinflation.  Therefore, the current inflation of the money supply is not a minor issue.  We will not experience a relatively minor increase in the consumer price index.  Our cost of living will not “just” increase.  There is a very real risk of a collapse in the legal tender of the United States.  As a result, an understanding of inflation and the knowledge of the true definition of inflation is of utmost necessity.