April 7, 2014
Why Keynesian Economists Don’t Understand Inflation
by Frank Hollenbeck on April 7, 2014
The “monetary cranks” and “ignorant zealots” of old are back preaching salvation if only we had more inflation. 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
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
Yet, the original, non-Keynesian quantity theory of money clearly shows that the demand
for money reflects, not just nominal income of the GDP deflator, but all possible transactions, which we cannot measure. Money is linked to prices of
anything that money can buy, consumer goods, stocks, bonds, stamps, land, etc. 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.
Note: The views expressed in Daily Articles on Mises.org are not necessarily those of the Mises Institute.
When commenting, please post a concise, civil, and informative comment.
Frank Hollenbeck teaches finance and economics at the International University of Geneva. He has previously held positions as a Senior Economist at the State Department, Chief Economist at Caterpillar Overseas, and as an Associate Director of a Swiss private bank. See Frank Hollenbeck's article archives.
You can subscribe to future articles by Frank Hollenbeck via this RSS feed.
From Mises, “Planning for freedom” 1950, 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.”