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Commodity Prices and Inflation: What's
the Connection?
[Note: Please be sure to read the
closing von Mises quote in this
piece.]
The latest data show that the yearly
rate of growth of the US consumer
price index (CPI) climbed to 4.1% in
May from 3.9% in the month before.
Most economists and Federal Reserve
policy makers attribute this to sharp
increases in commodity prices.
In his speech at the Federal Reserve
Bank of Boston, Fed Chairman Bernanke
said,
Inflation has remained high, largely
reflecting sharp increases in the
prices of globally traded commodities.
There is almost complete unanimity
among economists and various
commentators that inflation consists
in general increases in the prices of
goods and services. From this it is
established that anything that
contributes to price increases sets
inflation in motion. A decrease in
unemployment or an increase in
economic activity is seen as a
potential inflationary trigger. Some
other triggers, such as increases in
commodity prices or workers wages, are
also regarded as potential threats.
If inflation is just a general
increase in prices, as popular
thinking has it, then why is it
regarded as bad news? What kind of
damage does it do?
Mainstream economists maintain that
inflation causes speculative buying,
which generates waste. Inflation, it
is maintained, also erodes the real
incomes of pensioners and low-income
earners and causes a misallocation of
resources. Inflation, it is argued,
also undermines real economic growth.
Why should a general increase in
prices hurt some groups of people and
not others? And how does inflation
lead to the misallocation of
resources? Why should a general
increase in prices weaken real
economic growth? If inflation is
triggered by other factors, then
surely it is just a symptom and can't
cause anything as such.
We know that a price of a good is the
amount of money paid for the good.
From this we can infer that for any
given amount of goods, a general
increase in prices can only take place
in response to the increase or
inflation of the money supply.
Most economists, when discussing the
issue of general increases in prices,
which they label
inflation, never mention
the word
money. The reason for that
is the lack of a good statistical
correlation between changes in money
and changes in various price indexes
such as the CPI. Whether changes in
money cause changes in prices cannot
be established by means of statistical
correlation. We suggest that a
statistical correlation, or lack of
it, between two variables shouldn't be
the determining factor in establishing
causality. One must figure out by
means of reasoning the structure of
causality.
The Essence of Inflation
Historically, inflation originated
when a king would force his citizens
to give him all their 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
this Rothbard wrote,
More characteristically, the mint
melted and recoined all the coins of
the realm, giving the subjects back
the same number of "pounds" or
"marks," but of a lighter weight. The
leftover ounces of gold or silver were
pocketed by the King and used to pay
his expenses.
Because of the dilution of the gold
coins, the ruler could now mint a
greater number of coins for his own
use. (He could now divert real
resources to himself.) 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 the increase in the
amount of coins, prices in terms of
coins now go up (more coins are being
exchanged for a given amount of
goods). What we have here is
inflation, i.e., an expansion of
coins. As a result of inflation, the
ruler can engage in an exchange of
nothing for something. Also note
that the increase in prices in terms
of coins results from the coin
inflation.
Under the gold standard, the technique
of abusing the medium of 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 resulting from the increase
in receipts that are not backed by
gold yet masquerade as the true
representatives of money proper: gold.
The holder of unbacked receipts can
now engage in an exchange of nothing
for something. As a result of the
increase in the number of receipts
(inflation of receipts) we now also
have a general increase in prices.
Observe that the rise in prices
develops here because of the increase
in paper receipts that are not backed
by gold. Also, what we have is a
situation where the issuers of the
unbacked paper receipts divert to
themselves real goods without making
any contribution to the production of
goods.
In the modern world, money proper is
no longer gold but rather paper money;
hence inflation in this case is an
increase in the stock of paper money.
Please note we
don't say, as monetarists
do, that the increase in the money
supply causes inflation. What we are
saying is that inflation
is
the increase in the money supply.
We have seen that increases in the
money supply set in motion an exchange
of nothing for something. They divert
real funding away from wealth
generators toward the holders of the
newly created money. This is what sets
in motion the misallocation of
resources, not price increases as
such.
Real incomes of wealth generators fall
not because of a general rise in
prices but because of increases in the
money supply. When money is expanded —
i.e., created out of "thin air" — the
holders of the newly created money can
divert to themselves goods without
making any contribution to the
production of goods. As a result,
wealth generators who have contributed
to the production of goods discover
that the purchasing power of their
money has fallen since there are
now fewer goods left in the pool —
they cannot fully exercise their
claims over final goods since these
goods are not there.
Once wealth generators have fewer real
resources at their disposal, this will
obviously hurt the formation of real
wealth. As a result, real economic
growth is going to come under
pressure.
General increases in prices, which
follow increases in money supply, only
point to an erosion of real wealth.
Price increases, however, didn't cause
this erosion.
Likewise, it is monetary inflation,
and not increases in prices, that
erodes the real incomes of pensioners
and low-income earners. As a rule,
they are the last receivers of money —
often called the "fixed-income
groups."
According to Rothbard,
Particular sufferers will be those
depending on fixed-money contracts —
contracts made in the days before the
inflationary rise in prices. Life
insurance beneficiaries and
annuitants, retired persons living off
pensions, landlords with long-term
leases, bondholders and other
creditors, those holding cash, all
will bear the brunt of the inflation.
They will be the ones who are "taxed."
Can Increases in Commodity Prices
Cause Inflation?
We have seen that, according to
Bernanke and most economists, it is
increases in commodity prices such as
oil that are behind the recent strong
increases in the prices of goods and
services.
If the price of oil goes up, and if
people continue to use the same amount
of oil as before, people will be
forced to allocate more money to oil.
If people's money stock remains
unchanged, less money is available for
other goods and services, all other
things being equal. This of course
implies that the average price of
other goods and services must come
down.
Remember: a price is the sum of money
paid for a unit of a good. (The term
"average" is used here in conceptual
form. We are well aware that such an
average cannot be computed.)
Note that the overall money spent on
goods doesn't change; only the
composition of spending has altered,
with more on oil and less on other
goods. Hence the average price of
goods or money per unit of good
remains unchanged.
Likewise, the rate of increase in the
prices of goods and services in
general is going to be constrained by
the rate of growth of money supply,
all other things being equal, and not
by the rate of growth of the price of
oil.
It is not possible for increases in
the price of oil to set in motion a
general increase in the prices of
goods and services without
corresponding support from the money
supply.
Can Inflation Expectations Trigger a
General Price Rise?
We have seen that as a rule a general
increase in the prices of goods can
emerge as a result of the increase in
the amount of money paid for goods,
all other things being equal. The key
then for general increases in prices,
which is labeled by popular thinking
as inflation, is increases in the
money supply, e.g., the supply of US
dollars. But what about the situation
when increases in commodity prices
ignite inflation expectations, which
in turn strengthens the rate of
inflation? Surely then inflation
expectations must be also an important
driving factor of inflation? According
to Bernanke inflation expectations are
the key driving factor behind
increases in general prices,
The latest round of increases in
energy prices has added to the upside
risks to inflation and inflation
expectations. The Federal Open Market
Committee will strongly resist an
erosion of longer-term inflation
expectations, as an unanchoring of
those expectations would be
destabilizing for growth as well as
for inflation.
Once people start to anticipate higher
inflation in the future, they increase
their demand for goods at present thus
bidding the prices of goods higher.
Also, according to popular thinking,
workers expectations for higher
inflation prompt them to demand higher
wages. Increases in wages in turn lift
the cost of producing goods and
services and force businesses to pass
these increases on to consumers by
raising prices.
It is true that businesses set prices
and it is also true that businessmen,
while setting prices, take into
account various costs of production.
However, businesses are ultimately at
the mercy of the consumer, who is the
final arbiter.
The consumer determines whether the
price set is "right," so to speak.
Now, if the money stock did not
increase, then consumers won't have
more money to support the general
increase in prices of goods and
services.
Also, because of expectations for
higher prices in the future, consumers
will not be able to increase their
demand for goods at present and bid
the prices of goods higher without
having more money.
Consequently, the amount of money
spent per unit of goods will stay
unchanged.
So irrespective what people's
expectations are, if the money supply
hasn't increased, then people's
monetary expenditure on goods cannot
increase either. This means that no
general strengthening in price
increases can take place without an
increase in the pace of monetary
pumping.
Imagine that somehow the Fed did
manage to convince people that central
bank policies are aimed at stopping
inflation and maintaining price
stability, yet at the same time the
central bank also increased the rate
of growth of money supply. Even if
inflationary expectations were stable,
that destructive process would be set
in motion, regardless of these
expectations, because of the increase
in the rate of growth of money.
People's expectations and perceptions
cannot offset this destructive
process. It is not possible to alter
the facts of reality by means of
expectations. The damage that was done
cannot be undone by means of
expectations and perceptions.
Some economists, such as Milton
Friedman, maintain that if inflation
is "expected" by producers and
consumers, then it produces very
little damage. The problem, according
to Friedman, is with unexpected
inflation, which causes a
misallocation of resources and weakens
the economy. According to Friedman, if
a general increase in prices can be
stabilized by means of a fixed rate of
monetary injections, people will then
adjust their conduct accordingly.
Consequently, Friedman says, expected
general price increases, which he
calls expected inflation, will be
harmless, with no real effect.
Observe that, for Friedman, bad side
effects are not caused by increases in
the money supply but by its outcome —
increases in prices. Friedman regards
money supply as a tool that can
stabilize general increases in prices
and thereby promote real economic
growth. According to this way of
thinking, all that is required is
fixing the rate of money growth, and
the rest will follow.
The fixing of the money supply's rate
of growth does not alter the fact that
money supply continues to expand.
This, in turn, means that it will lead
to the diversion of resources from
wealth producers to non–wealth
producers. The policy of stabilizing
prices will therefore generate more
instability through the misallocation
of resources.
Can Inflation Emerge While Prices Stay
Unchanged?
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 this case the general
increase in prices is associated with
inflation.
But now consider the following case:
the rate of growth in money is in line
with the rate of growth in goods.
Consequently, the prices of goods on
average don't change. 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 is
now able to exchange nothing for
something irrespective of the rate of
growth of the production of goods.
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. This diversion is possible
because of the increase in the number
of diluted coins, i.e., the inflation
of coins.
The same logic can be applied to
paper-money inflation. The exchange of
nothing for something that the
expansion of money sets in motion
cannot be undone by an 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.
According to Rothbard,
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.
Conclusion
Contrary to the popular definition,
inflation is not about a general rise
in prices but about increases in money
supply. The general increase in prices
as a rule develops because of the
increase in money. The harm that most
people attribute to increasing prices
is in fact due to increases in money
supply. Policies that are aimed at
fighting inflation without identifying
what it is all about only make things
much worse.
When inflation is seen as a general
increase in prices, then anything that
contributes to price increases is
called inflationary. It is no longer
the central bank and
fractional-reserve banking that are
the sources of inflation, but rather
various other causes.
In this framework, not only does the
central bank have nothing to do with
inflation but, on the contrary, the
bank is regarded as an inflation
fighter. On this Mises wrote,
To avoid being blamed for the
nefarious consequences of inflation,
the government and its henchmen resort
to a semantic trick. They try to
change the meaning of the terms. They
call "inflation" the inevitable
consequence of inflation, namely, the
rise in prices. They are anxious to
relegate into oblivion the fact that
this rise is produced by an increase
in the amount of money and money
substitutes. They never mention this
increase. They put the responsibility
for the rising cost of living on
business. This is a classical case of
the thief crying "catch the thief."
The government, which produced the
inflation by multiplying the supply of
money, incriminates the manufacturers
and merchants and glories in the role
of being a champion of low prices
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