Monday, January 12, 2009

Inflation and Deflation

Inflation is frequently defined as “a rise in the general price level.” Deflation is defined as “a fall in the general price level.” These definitions are both erroneous and harmful. When an effect (a change in the level of prices) is mistaken for a cause (in this case, a cause of deflation or inflation) efforts to address the problem will be misdirected. Sometimes it leads to trying to fix what isn’t broken, and other times to taking actions which aggravate rather than relieve a real problem.

Inflation and deflation are "everywhere and always"1 monetary phenomena--by which I mean, they occur as a result of a change in the quantity of money. Inflation is the decline in the purchasing power of money due to an increase in the supply of money more rapid than the increase in real wealth.2 When the supply of money is kept constant, prices will reflect the existing relationship between supply and demand.3 The greater the supply, the less valuable something is. As economic value is expressed in terms of demand, this means the greater the supply the less the demand. The “equilibrium price” is that price at which all of the existing supply will be purchased (i.e. demanded.) Prices will fall if supply goes up relative to demand and will rise if demand goes up relative to supply. In a system of constant money, changes in prices reflect changes in the supply and demand of the various goods and services4 available for exchange.

Money itself is effected by the law of supply and demand. The greater the supply (the larger the quantity of money) the less valuable money is in terms of goods. In other words, it takes more money to purchase the same supply. Prices rise. The opposite is also true: a contraction in the money supply will lead to falling prices as the existence of less money makes each unit of money more valuable.

So, the quantity (supply) of money has definite effects on prices by its ability to change demand (the willingness and ability to spend money.) When more money is available, a larger amount of money can be offered to purchase the same goods as before. Prices are also affected by the availability of goods. An increased supply of goods will also result in lowering the equilibrium price. To the extent that the increase in supply is due to an increased productivity (increased efficiency in labor and/or materials) the fall in prices will not have an adverse effect on profitability, total sales revenues or ability to repay debts. Quite the opposite. An increase in the supply of goods due to increased productivity is the engine of economic progress and the cause of a rise in the standard of living. Less of one’s labor is needed to obtain the same or greater amount of goods. To equate falling prices due to an increased productivity with a fall in prices due to a contraction in the quantity of money is to equate a beneficial situation with a harmful one. For this reason, defining inflation and deflation simply in terms of a change in prices fails to distinguish between these fundamentally opposite economic situations.

Fear of falling prices, irrespective of the cause of the fall, has misled many economists. The siren of “price stability” has lured both Keynesians and Monetarists onto the rocks of inflationary destruction. In contrast to falling prices due to an increase in the supply of goods, falling prices due to a contraction in the money supply will lead to a fall in total sales revenue, profits and thus a fall in employment and the ability to repay debts-the meaningful definition of deflation. But a large contraction in the money supply can only occur in a system that first allows a large growth in the money supply. This increase or decrease of the money supply out of sync with the production of real wealth is the ultimate cause of the boom and bust of the business cycle. Inflation, an increase in the money supply, stimulates a boom. Deflation, a contraction in the money supply, results in the bust.

What kind of money is vulnerable to significant and recurrent inflation and deflation? Money that is disconnected from the production of actual wealth, ie. fiat money and fiduciary money created through credit expansion. A commodity money, such as gold, can increase in supply, but its increase is limited. This is illustrated by the chart below showing the historical growth of gold as a percent of the world gold stock.

World Gold Production as a Percentage of World Gold Stock 1800-2000

(Source: Salsman, 19955 Click on images to enlarge.)

Once gold is brought into existence, only a negligible amount is used up6. The rest remains in existence as a store of value. The stability in the stock of gold is in marked contrast to money created out of thin air, either by the Federal Reserve or through the pyramiding of debt made possible by a fractional reserve banking system undisciplined by commodity money. Fiat and debt money can go out of existence as easily as it was created. The chart below illustrates the historical instability of the fiat money supply compared to the supply of gold. (Money supply is in red; gold stock is in black.)

Total Gold Supply vs. Money Growth Supply Annual Rate of Change 1933-2008

(Source: Gold Fields Mineral Resources, Ltd; KITCO)

This can also be demonstrated by comparing the purchasing power of gold to that of the U.S. dollar.

Purchasing Power of Gold and of the Dollar 1792-1994 (1792= 1.00)

(Source: “Gold and Liberty” by Richard M. Salsman7)

Or perhaps more dramatically when superimposed as below:

Purchasing Power of Gold and the U.S.Dollar 1792-1994

(Source: “Gold and Liberty” Richard M Salsman.8)

Prices rise and fall.

Prices can change as a result of shifting supply relative to demand, thus redirecting resources to where the demand is greatest. Or, prices can change because of a change in the quantity of money, leading to the inefficiencies of inflation and deflation. When prices simultaneously reflect both a change in supply/demand and a change in the quantity of money, there is no way to distinguish how much of the change is due to which cause. In this way, a changing quantity of money masks and distorts the signals which are essential for the efficient allocation of resources. Without accurate price signals, savings are malinvested, excessive risk is assumed, consumption exceeds production. Eventually, reality catches up with the falsely inflated values. The deflationary realignment is painful and destructive. To preserve accurate price signals and prevent the inflation/deflation boom-bust cycle, we must have a money which is sound and constant. These are the benefits of a commodity money, like gold.

An essential function of definitions is to enable us to isolate and distinguish different phenomena one from the other in order to think about them more clearly and accurately. Definitions of inflation and deflation that fail to distinguish between the differing causes for a rise or fall in prices can not serve this function. In fact, they do the opposite. Inflation and deflation disrupt economic calculations and are therefore destructive to the creation of wealth. A fall in prices due to increased productivity is accompanied by a rise in the standard of living. Only when this distinction is understood can we hope to respond appropriately to changing economic circumstances.

1. This phrase is from a frequently quoted description of inflation in Monetary History of the United States 1867-1960 by Milton Friedman and Anna Schwartz.
2. An alternate definition is “an increase in the quantity of money at a rate more rapid than the increase in the supply of gold and silver.” Gold and silver simply stand in place as a direct unit of measure of the value of all other wealth—wealth being the material goods made by man; also land and natural resources in so far as man has made them usable and accessible. All definitions are derived from Capitalism: A Treatise on Economics by George Reisman.
3. Demand is defined as the willingness and ability to purchase and is quantified by dollars actually spent.
4. To simply the language, for the rest of the post I will use “goods” to signify both “goods and services.”
5. Salsman, Richard, “Gold and LibertyEcon Ed Bull v.XXXV no. 4 1995, p. 27
6. An insignificantly small amount (relative to total existing stock) of gold is actually consumed in medical other commercial uses. The rest remains easily retrievable.
7. Salsman, 1995 p. 128-9
8. Salsman, 1995 p. 31


Michael Labeit said...

When discussing inflation, I usually refer to an increase in the money suuply as "monetary inflation," an increase in prices as "price inflation," and identify the long-term version of the latter as an exclusive consequence of the former. It is concievable that drastic movements in supply and demand may cause very-short term price inflation. The sustained price inflation that we see however is the exclusive product of monetary inflation.

Beth said...

Can you elaborate how drastic movements in supply and demand would effect an entire economy? I can see how it could effect some segment(s) but not how it could cause generalized price increases.

Michael Labeit said...

These are theoretically possible situations.

Say, an aggressor nation has its service, industrial, and manufacturing sectors obliterated by a retaliating nation. Capital goods in such a situation would be eliminated. This would drastically reduce supply and would make prices for such goods rise in general, if demand were constant.

Let's say that instead of staying, the citizens of this defeated aggressor nation become refugees and flee en masse to a bordering country. Population is a determinant of demand. If the population can go up fast enough, the result could be very-short term price inflation.

I ensure that I say "very-short" term inflation because as prices rise due to either demand or supply movements, entrepreneurs will swoop in with purchased productive factors and remove all productive mal-adjustments, satisfying consumer demand and garnishing profits.

Price inflation will never occur in a pure free-market - there would be no central banking and entrepreneurs and speculators would act too quickly to streamline prices. However, it is theoretically possible for price inflation to be caused by non-monetary phenomena, albeit only in non-market nations. But, as Friedman held, historically, inflation is anywhere and everywhere a monetary phenomenon.

Michael Labeit said...

I often differentiate "monetary" and "price" inflation for my students. We've been told in economics class that inflation can be "cost-push" and "demand-pull" - Keynesian fiction in other words. The dual concepts "monetary inflation" and "price inflation" refer to cause and effect, respectively. "Inflation" used by Reisman subsumes both cause and effect. The difference is linguistic - the meaning is the same. I simply think my students may be able to comprehend the economic situation at a greater degree if the cause and effect are identified and labelled with exclusive concepts. The difference is still menial. Rand held that concept-formation should be tailored to our conceptual needs.

Per-Olof Samuelsson said...

Yes, you *can* make a distinction between "monetary inflation" and "price inflation" and say the first is the cause of the second. But I think it is better to stick to the proper ("misesian" or "reismanite") definition.

I think this is even clearer with the concept "deflation". Falling prices caused by an increase in production and falling prices caused by a contraction of the money supply are two entirely different phenomena. Lumping both phenomena together under the label "deflation" makes it impossible to think clearly about the subject.

And if you haven't done so already, read George Reisman's latest blog post on the subject of deflation. It explains the matter better that I can do in a short comment.

Beth said...

"Falling prices caused by an increase in production and falling prices caused by a contraction of the money supply are two entirely different phenomena. Lumping both phenomena together under the label "deflation" makes it impossible to think clearly about the subject."

I completely agree.