The true nature of inflation

Price increases are often incorrectly viewed as inflation, leading to a series of policy mistakes

Business Standard, Aug 19, 2004

Recent indicators suggest that consumer prices are rising rapidly. Consumer prices recorded a seasonally adjusted annual rate (SAAR) of 4.8 per cent in the second quarter after advancing at a 5.1 per cent rate over the first quarter of 2004.

So far, the year-to-date annual rate is 4.9 per cent in contrast to an overall increase of 1.9 per cent in 2003. And the wholesale price index rose to more than 7.5 per cent, up from 4.27 per cent compared with the previous year.

Blame for these rises has been placed upon everything from an erratic monsoon, increased fuel prices and commodities like minerals or the higher excise duty change on steel.

This depiction reveals a common misconception about the true nature of inflation. As it is, the orthodox economic view wrongly defines inflation as rising prices while incorrectly depicting money as a passive or neutral agent.

Until the 1930s, economists generally accepted that inflation described excessive increases in the rate of growth of the money supply. Viewed in this way, rising consumer and producer prices are among the potential effects of an inflated money supply.

Focusing upon consumer or producer prices creates a misleading conclusion about the nature of inflation of the money supply. Part of the misplaced obsession with consumer purchasing power comes from the erroneous assumption that aggregate demand is the principal engine of economic growth.

Since price increases are often incorrectly viewed as inflation, additional rounds of policy mistakes follow from this fundamental mistake.

Policy decisions made in response to price increases often translate into a redistributive political game since their effect along with increased debt distress falls most heavily upon low-income groups.

Yet people seldom understand that monetary and political authorities caused these developments. Instead, blame is incorrectly placed on markets or businesses.

Central banks act as cartels that allow the unsupported issuance of monetary units, often to finance government deficits. Instead of printing new money, central banks can expand the money supply by increasing the reserves in the banking system.

In turn, commercial banks operate a pyramid scheme that allows them to issue checkbook money as a multiple of their own reserves. This fractional reserve banking system allows banks to engage in credit creation by issuing notes and bank balances unsupported by any new wealth.

Since money substitutes are created out of thin air, the whole process is a risky venture. Such a practice would be fraudulent except that it has a legal basis whereby central banks give commercial banks the legal right to issue “counterfeit” money.

This counterfeiting process results from the fact it allows more titles to be created against the existing amount of property and resources even though the actual amounts remain unchanged. A completely new means for purchasing was concocted with no underlying support for it.

Inflating the money supply has been associated with a so-called wealth effect that supposedly drives consumption and growth. But this concept does not hold up to a simple logic check. Consider that if individuals continue to consume by borrowing while their incomes fall, this spending would be offset by lower expenditures by lenders.

Total spending would remain unchanged because borrowing and lending involve the temporary transfer of purchasing power from one person to another. Like any other redistribution, these transfers cannot increase actual total spending.

However, a fractional banking system allows borrowing to increase spending since there is more credit available through a virtual process that approximates printing more pieces of paper.

When central bank policy accommodates continuous credit expansion, housing prices will be pushed up and create (illusory) increases in the paper wealth of homeowners. But the increasing asset values do not drive borrowing. Both are being increased by credit expansion arising from inflationary monetary policy.

It turns out that only rising wealth from higher productivity can generate a sustained net inflow of funds to boost stock market performance. This will drive economic growth and motivate investment and innovation for further boosts in productivity that push up corporate profits and stock prices.

With so much historical evidence, it is almost criminal that central bankers fail to recognise their responsibility in creating the conditions for speculative bubbles to form. While lessons of monetary history are being ignored, the nature of inflation is being used in a confused manner.

Most central banks have pursued a reckless policy of monetary expansion. As always, high rates of money supply growth and loose credit policies helped create an illusion of macroeconomic vitality.

Meanwhile, unsustainably low interest rates lured businesses and households into making decisions that created distortions and imbalances in the economy.

An inevitable bust will occur whereby injured parties will demand relief from the same reckless political and monetary authorities that set up the conditions that are the cause of distress.

But there is some good news for India. Rising productivity and reduced restrictions on commerce may soften the inevitable restructuring of the economy by liquidating excess capacity caused by ill-advised monetary and credit policy.

(The writer is a research scholar at the Centre for Civil Society in New Delhi and Professor of Economics at Universidad Francisco Marroquín in Guatemala)