What Actually Causes Inflation (and who gains from it) … I made a post two weeks ago in which I explained that the popular view of inflation (wherein it is caused by money growth) depends critically on assumptions that do not hold in the real world. Money comes into existence when someone adds it to her portfolio of assets. This occurs either when she borrows money (which creates new cash from reserves) or sells securities to the Federal Reserve (which injects new cash into the system). Neither of these scenarios allows the central bank to increase the supply of money beyond demand, the story told by those in the money growth ==> inflation camp. Instead, inflation happens first. This then means that agents need more cash for transactions, leading them to borrow more or sell government securities to the Fed. Thus, the money growth accompanies inflation, but it does not cause it. – Forbes/John T. Harvey/Pragmatic Economics Blog
Dominant Social Theme: Inflation is caused by wage push and other market-based factors.
Free-Market Analysis: The world is full of clever, insightful and well-educated people, and John T. Harvey, a blogger columnist at Forbes (his column is called Pragmatic Economics), is one of them. Not only is he a good writer, he's even a witty one, which is unusual for an economist. Who is he? Here's a bit of his impressive bio:
I am a Professor of Economics at Texas Christian University, where I have worked since 1987. My areas of specialty are international economics (particularly exchange rates), macroeconomics, history of economics, and contemporary schools of thought. During my time in Fort Worth, I have served as department chair, Executive Director of the International Confederation of Associations for Pluralism in Economics, a member of the board of directors of the Association for Evolutionary Economics, and a member of the editorial boards of the American Review of Political Economy, the Critique of Political Economy, the Encyclopedia of Political Economy, the Journal of Economics Issues, and the Social Science Journal.
As smart and well-informed as he is, it seems to us in a recent series of blog-reports (see excerpt above) that Professor Harvey is building a case for a kind of neo-Keynesianism, so named for John Maynard Keynes, the great socialist economist of the early and mid-20th century. He is not alone.
We have noticed this trend of late. Using the Internet, Lew Rockwell and the Austrians have been so successful at presenting the Misesian money-supply argument for inflation that there is not much of John Maynard Keynes arcane body of thought left standing today (except maybe the odor of his exceptional arrogance).
Even on Google, Misesian cites outnumber Keynesian ones. And 20 years ago, quite literally, no one had ever heard of Ludwig von Mises. When his name was mention in economic textbooks, the biographical vitriol positively oozed. Given what has occurred as a result of what we have taken to calling the Internet Reformation, it was inevitable that the powers-that-be would begin to push back. Neo-Keynesianism must inevitably surge, like a counter reformation.
Boy, did the Anglosphere power elite hate Mises. It wasn't even his grasp of monetary economics or the business cycle (though those were bad enough). No, it was his eloquent presentation of human action that poisoned the well. Once one admits that all government plans are doomed to fail, to one degree or another, because human beings will change their behaviors in unanticipated ways over time. Thus government plans go astray.
Mises, therefore, called into the question the fundamental reason for government, or certainly for big government. He proved it couldn't work, basically, though he was too polite to say so in exactly those words. (That was left to his disciple Murray Rothbard.)
Anyway, this is why government laws always have unintended consequences. Every government action results in a price fix and every price fix distorts the economy. This is also why central banking doesn't operate properly, or at least in the ways that its defenders expect it to.
For Professor Harvey, (as an apparent, putative Neo-Keynesian – our term, not his) central banking is not so bad. It's mostly ineffective ( or so he seems to argue). He has now written a number of articles about it over at Forbes. His basic argument from what we can tell (and this is presented in another article) is that it is not how much money central banks print that causes inflation, it's how much money circulates. This, he reminds us, elsewhere, is monetary velocity.
Of course, it is not REALLY monetary velocity that causes money to circulate. Monetary velocity is actually a byproduct of the DEMAND FOR MONEY. The money has to be available, but people have to want to use it. This is why the Misesian business cycle works the way it does. The abundance of available currency at banks, courtesy of central bankers, may eventually trigger a boom (coming after a bust). This is evidently and obviously why someone like Ben Bernanke is flooding the banking system with currency. He is hoping to spark a boom, or at least the beginnings of one.
Once a boom begins, the economy expands and eventually overexpands, leading to a bust. The process continues until the economy itself is so distorted and wretched that monetary stimulation doesn't work anymore. That's where we are today, by the way. The pundits say otherwise but the system is in no way ready to rebound. We've speculated it is already dead or at least withering.
People are too tired to borrow and even if they could find a way to put the money to work, they can't figure out which businesses are solvent and which ones are being propped up by central banking currency flows. Additionally, banks themselves may be reluctant to lend in such an environment. This is how a central banking economy dies.
Professor Harvey is apparently not so sure of any of this. He doesn't even define inflation the monetarists do – as an increase in currency (swelling bank reserves or, perhaps, circulating). He defines inflation as occurring "when the average price of those goods and services has increased." This would seem to be the Keynesian definition of inflation.
The professor then lists the causes of what we would call "price inflation." First, he explains, comes Market Power. He uses OPEC as an example. At times, OPEC has been in a powerful position, one in which it has been able to avoid competition. In such a situation, a producer can drive prices up hard and fast, and OPEC did. Market power.
"Money supply growth did not cause prices to rise," he writes. "OPEC's attempt to grab a larger income share did. No amount of controlling the money supply was going to eliminate the ultimate impact of rising oil prices: the redistribution of income towards those countries and the oil industry."
Demand Pull is another cause of price inflation. When the economy is humming along, bottlenecks may appear for certain goods and services. In a high-productivity environment, suppliers are willing to pay higher prices for the supplies they need. They "demand" the materials and thus are willing to pay higher prices, which then ripple through the economy. In such a situation, "the Fed presumably accommodates" (makes more money available).
An Asset Market Boom is a third way to generate price inflation. Here's the professor's explanation: "When speculative money bids up the price of a commodity future, this creates an incentive for those actually selling the commodity to withhold supply today in favor of the future (when prices will presumably be higher). The rising spot price then convinces the speculator that her bet had been correct, and she increases her position. This may drive futures prices even higher, and so on. Thus, a goods price is driven up by the price of a financial asset."
Supply Shock is the last way to generate price inflation, according to the professor. (This seems to us a lot like Demand Pull, but, hey, what do we know?) Anyway, the idea is that an in-demand item is suddenly withdrawn from the market for any one of a number of reasons. "If a storm rages through the Gulf of Mexico, taking out oil derricks and refineries along the way, this may well raise the price of oil and gas," the professor explains. "As it should, for this creates incentives to build more derricks and refineries and for consumers to find alternate energy sources."
His conclusion: "The bottom line is that there are a number of processes that can create inflation, none of which starts with, 'the money supply increases.'" Someone, he writes, make a conscious decision to raise a price or wage, and they must be able to make this stick. "Because every higher price you pay means someone is getting more income, inflation causes a redistribution of income. Sometimes it does so in a manner that we would endorse and sometimes not. But in any event, it causes a rise in the demand for money that the Fed will almost certainly accommodate– and rightfully so."
The professor, finally, is wistful … "I'm afraid this more realistic perspective does not offer a nice, simple rule as in the money growth [equals] inflation camp. That said, neither do they since that's not how the world really works! In reality, monetary policy does not cause inflation, and it is not well placed to stop it … Prices are determined elsewhere in the system."
Again, all of this seems Keynesian to us. Our elves are apt to stick to the Misesian definition of inflation, which has to do with the money supply and the circulation of money. We would also like to see a return to circulating gold and silver (or certificates thereof).
The circulation of money metals circumvents central banking profligacy. When there is too much money in the system, hoarders cease to circulate their gold and silver and mines shut down. This diminishes the amount of money in the system and causes more demand. When there is more demand, the price of money metals rises and hoarders dishoard and mines open back up. This is the way that supply and demand works in the FREE MARKET. There is no other way to circulate money that does not result in a PRICE FIX. And a price fix causes … etc. etc.
Indeed, it bears repeating a thousand times. There is NO WAY that the wise of men of central banks ever know when enough money has been printed. In the good times they print too much; in the bad times they print too much. There seems to us NO WAY one can mount a rational defense of central banking. That brings us back to the excerpt at the beginning of this article …
The professor states that money comes into existence only when someone adds it to her portfolio of assets. His point in several articles is that the central bank (the Fed) can print money but cannot inject it into the economy unless it is wanted. Only "demand" can generate this circulation. "Thus, the money growth accompanies inflation, but it does not cause it."
This issue we have with this comes partially from Say's Law – the famous law that explained how supply could stimulate more supply. We would argue that when central banks print more currency than the economy needs at a given time, the availability of the currency itself drives demand. People may come up with all sorts of needs for cheap cash that they would not have otherwise. And in a money-boom environment, banks are eager to lend.
It may be unfair to label the professor a neo-Keynesian, but his insistence that inflation is not the product of an abundance of circulating money-stuff but a rise in prices, and his explanation that money growth "accompanies [price] inflation" provides us with reason to think it so.
He is not at alone, of course. It is a positive sub dominant social theme – a rising tide of voices with various levels of erudition (the professor being among the most erudite) explaining that inflation cannot possibly be supply driven. It is, they say, something else. Perhaps a price phenomenon.