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Home | Library | Commodity Prices and Inflation: What's the Connection?

Commodity Prices and Inflation: What's the Connection?

July 1, 2008

Tags The FedFinancial MarketsMoney and BanksMonetary TheoryOther Schools of Thought

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.[1]

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.[2]

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."[3]

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.[4]

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.[5] 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.[6]

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.[7]

Notes

[1] Ben S. Bernanke. "Outstanding Issues in the Analysis of Inflation." Speech at the Federal Reserve Bank of Boston June 9, 2008.

[2] Murray N. Rothbard. What Has Government Done to Our Money?

[3] Murray N. Rothbard. What Has Government Done to Our Money?

[4] Ben S. Bernanke. "Outstanding Issues in the Analysis of Inflation." Speech at the Federal Reserve Bank of Boston June 9, 2008.

[5] See Friedman's Dollars and Deficits, Prentice Hall, 1968, pp.47–48.

[6] Murray N. Rothbard. America's Great Depression. 153.

[7] Ludwig von Mises. Economic Freedom and Interventionism. 94.

 


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