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Why Keynesian Economists Don’t Understand Inflation

Economics / Inflation Apr 07, 2014 - 06:01 AM GMT

By: Frank_Hollenbeck

Economics

The “monetary cranks” and “ignorant zealots” of old are back preaching salvation if only we had more inflation.[1] Keneth Roggoff and Fed President Charles Evans did not mince words, while others have been more circumspect. Christine Lagarde warns us of the “ogre of deflation” and the “risks” of low inflation, while others have been urging easier monetary policy to reduce the value of the yen or the euro. Of course, it’s much easier to let this inflation tiger out of its cage than to get it back in.


We have ample evidence that once inflation picks up, it’s extremely difficult to control. Inflation in the US was 1 percent in 1915, almost 8 percent in 1916, and over 17 percent in 1917. It was about 2 percent in 1945 and jumped to over 14 percent by 1947. During the 1970s, inflation was mild in 1972, and climbed to 11 percent by 1974 and stayed at very high rates until Volker raised interest rates to 19 percent to tame the beast.

Even if you agree a 2 percent inflation target is an appropriate policy, inflation should, at least, be measured correctly. Proper measurements are unlikely since mainstream economists today, unfortunately, use a simplified version of the original quantity theory of money. In this version, money is linked exclusively to nominal income, and the CPI or GDP deflator are used as a proxy for prices of the goods and services in nominal income. This version is obtained from Keynes’s theory of liquidity preferences.

Yet, the original, non-Keynesian quantity theory of money clearly shows that the demand for money is to conduct all possible transactions, and not just those that make up nominal income. Money is linked to prices of anything that money can buy, consumer goods, stocks, bonds, stamps, land, etc. From this, an average price cannot be measured since appropriate weights are not obtainable. The use of the simplified, Keynesian version in economic textbooks and by the professional economist has caused immense damage. When your theory is wrong, your policy prescriptions will likely also be wrong.

Unnoticed by many mainstream economists is the fact that we are actually having the inflation everyone was so worried about back in 2009. It is simply showing up in asset prices instead of consumer prices. For some reason we consider higher food prices as bad and something to be avoided, while higher home prices are viewed as a good thing and something to be cheered. But they are both a reduction of your purchasing power. Today, home prices outpace wage growth significantly in many markets, and remain at high bubble-like levels, pricing homes out of reach of many young couples. Their incomes have less purchasing power: the money can buy less of a house, just like it can buy less of a hamburger.

By setting an inflation target, the FED did not let deflation run its course after the crash of 2008, and that was a big mistake. During the 2001-2007 boom years, housing prices shot up. This speculative bubble led to massive overbuilding of both private homes and commercial properties.

Deflation would have allowed a realignment of relative prices closer to what society really wants to be produced, but by inflating the money supply, the FED interfered with this essential clearing process. Housing prices should have dropped, much, much more than they did relative to other prices. Housing should then have remained in a slump possibly for a decade or more, until this overhang of construction had been cleared off. The new ratio of relative prices would have allowed resources to move into the production of goods and services more in line with what society would demand in a functioning market. The carpenter might have moved on and worked on an oil rig, possibly at an even higher salary. But that did not happen.

Today, housing is back, with price increases at bubble-era levels and construction activity picking up. Yet, the overhang has not disappeared. It has just been left in limbo, because of the “extend and pretend” strategy of banks made possible by the central bank’s massive printing over the last five years. Of course, when the music, or money printing, stops, the adjustment in housing will be even more disastrous.

The Fed should draw several lessons from history about inflation. The first is that an ounce of prevention is worth a pound of cure. You treat inflation like sunburn, by protecting yourself before your skin turns red. Second, the FED should not be concerned with consumer price inflation, but the increase in all prices which we are incapable of measuring (the weights being impossible to calculate). The recent increase in asset prices, such as stocks or agricultural land prices should be a strong warning signal.

The real solution is to end fractional reserve banking. The central bank would then be superfluous. It would not be missed. Its record at counterbalancing the negative effects of fractional reserve banking has been disastrous, and if anything, it has made things much worse.

If banks were forced to hold 100 percent reserve, neither the banks nor the public could have a significant influence on the money supply. Banks would then be forced to extend credit at the same pace as slow moving savings. Credit would finally reflect the real resources freed up to produce capital goods. The money supply could then be what it should always have been, a means of measuring exchange value, like a ruler measuring length, and as a store of value.

Notes

[1] From Mises, “Planning for freedom” 1952, talking about the post Malthus-Say debates of the early 1800's. “Those authors and politicians who made the alleged scarcity of money responsible for all ills and advocated inflation as the panacea were no longer considered economist but “monetary cranks”. The struggle between the champions of sound money and the inflationist went on for many decades. But it was no longer considered a controversy between various schools of economist. It was viewed as a conflict between economist and anti-economist, between reasonable men and ignorant zealots.”

Frank Hollenbeck, PhD, teaches at the International University of Geneva. See Frank Hollenbeck's article archives.

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© 2014 Copyright Frank Hollenbeck - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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