Battle4Liberty

Andrew Wilkow and I recently discussed Paul Krugman’s piece in the New York Times. The left-leaning economist called for more inflation as a cure for the nation’s economic ills. My comments on the show generated a lot of email so I am following up with a blog post.

Before we get to Krugman, let’s start with a few definitions. In a classic sense, INFLATION occurs when the money supply expands and DEFLATION occurs when it contracts. More money in circulation means that each dollar is worth less, so inflation typically translates into higher prices, sooner or later. Today, the word INFLATION is often used when we are really referring to PRICE INFLATION—an increase in a market basket of goods and services—but there is always a lag between expansion of the money supply and price hikes. The Fed has expanded the money supply recently, which means that prices down the road will be higher than they otherwise would have been. This to be an economic certainty, although we don’t know when prices will rise, by how much, and to what extent some of the change could be mitigated by deflationary pressure. As Milton Friedman put it, “[price] inflation is always and everywhere a monetary phenomenon.”

We can illustrate this with a simple example. Consider a small island economy where everyone agreed to use a certain type of shell as money, and 1,000 shells were in circulation. A coconut costs 2 shells and a pineapple costs 1 shell based on scarcity, preferences for each, difficulty in harvesting, and other market factors. Suppose that I uncovered a box of 1,000 additional shells buried by previous inhabitants. The money supply would double at that time and I’d be relatively rich, but prices would not change immediately, especially if nobody else knew of my discovery. As I began to spend these shells, however, the total number in circulation would rise, providing others with extra shells to make more purchases of their own. This increase in demand would enable sellers to raise prices. Eventually—when all of the additional 1,000 shells are in circulation—prices would rise proportionately to the increase in the money supply. A coconut would cost 4 shells and a pineapple would cost 2 shells. If this were not true, then economies could prosper by simply printing more money. It’s been tried before, but has never succeeded.

Interestingly, and contrary to common belief, inflation doesn’t occur naturally. In fact, without expansion of the money supply, many prices would decline as innovation and technology enable us to produce more for less.  Keynesian economists like Krugman like to see modest inflation. Their greatest fear is deflation. When prices are falling, they argue that consumers are more likely to hold on to their money in hopes of cheaper and better prices in the future. This would reduce demand even further and lead to greater unemployment, more deflation, and a downward spiral. Hence, government must intervene to keep demand rising.

But this argument is shortsighted. It fails to consider adjustment mechanisms already built into the market. Computers get better and cheaper every year, but this fact doesn’t keep us from buying one. If deflation automatically creates a downward spiral, then why doesn’t inflation automatically create an upward spiral?

The key point here is that promoting inflation is, by definition, consistent with central economic planning. Deflation empowers the holder of money because his spending power increases automatically. Inflation—particularly accompanied by a Fed that keeps interest rates artificially low—empowers the government because those who have money must either spend it or put it at risk (typically in the stock market) to avoid losing value. This is financial manipulation; it punishes savings and places individual wealth at the mercy of the central planners.