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Thursday, February 02, 2006 3:29 PM


Inflation: What the heck is it?


Inflation has at least 8 distinctly different definitions that I can readily find, and probably a whole lot more that I have not yet found.

Commonly Used Definitions

  1. Decline in purchasing power of the currency held
  2. Rising prices in general (essentially the same as #1 although some might disagree)
  3. Rising consumer prices (CPI)
  4. Rising producer prices (PPI)
  5. Rising prices due to expansion of money supply
  6. Rising prices due to expansion of money supply and credit
  7. Expansion of money supply
  8. Expansion of money supply and credit
Four of those definitions refer to money supply. That brings up another issue. When one refers to "money supply" are they talking about M1, M2, MZM, Money AMS (Austrian Money Supply), or simply the amount of money they have in their bank account or wallet at the time of the conversation? Definitions 5 and 6 refer to "rising prices" yet fail to distinguish between consumer prices, producer prices, or simply prices in general. It seems we could easily add a lot more definitions.

Furthermore, some people make no distinction between money and credit but others do as noted by choices 5 thru 8. Still others insist than in the fiat world we are in, the web is so tangled between money and credit that this mess is not even worth bothering to figure out. Those folks simply hold gold and wait for "The Crash".

The thing is, it is simply impossible to argue about inflation (or anything else) unless one can agree on a definition. Like it or not, we live in a fiat world. Therefore we must attempt to have sound definitions that best describe the fiat world we are in.

A Dictionary Definition

Dictionary.com defines inflation as: A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.

One might commend dictionary.com for making the distinction between money and credit, but others might take exception to "consumer prices" vs. "prices in general", and still others might argue endlessly about what "purchasing power" means. The real problem with the definition however, is that it puts the cart before the horse.

The Cart before the Horse

The problem with definitions that have a "because of" clause is that it impossible to know exactly why prices are rising or falling. Should rising oil prices due to peak oil, geopolitical concerns, hurricanes, or other supply disruptions really constitute inflation? More to the point: Is there any possible way to decide what % of the increase in the price of oil (or anything else) was "caused by an increase in available currency and credit beyond the proportion of available goods and services"?

The answer to that latter question is easy: of course not. Furthermore, the natural state of affairs is decreasing prices because of increasing productivity (more goods produced by less labor) thereby causing a drop in prices over time. One farmer today produces as much wheat or corn as did 20 or even 100 farmers not that long ago. Unions strive to protect jobs even though one worker today produces more cars than several workers a decade ago.

Dictionary.com thus proposes a definition of inflation that simply can not be measured. The problem is the "because of" clause that puts the cart before the horse.

Is Price all that Matters?

Of course those in the "price is all that matters" camp have no such problems. To them, prices of a basket of goods and services rose, therefore inflation rose. A big problem for those in this camp is that rising asset prices (such as stock market equities) are not properly accounted for in any known basket of goods and services.

Some might argue that that problem can be solved by including stock market prices in the basket of goods and services. Unfortunately that further compounds the problem by orders of magnitude. How does one decide which stocks to include in the basket as well as the relative weighting of those stocks? Furthermore, is it really valid to call genuine improvements in business conditions "inflation"?

Even without the problem of equity assets, there is a huge problem of selecting a basket of goods and services that works for both consumers and producers. Not only is it impossible to accurately pick a representative basket of goods an services that properly measures "purchasing power", it is also impossible to make accurate quality judgments about the prices of goods in that basket.

For example: double pane insulated argon gas filled windows are now common. How does one measure the price of those windows with windows thirty years ago when such a thing did not even exist? How does one accurately measure the relative values of such windows vs. the windows of yesteryear? It simply can not be done! Practically speaking, the price drop is 100% because one could not get those windows at any price if you go back far enough.

How long ago was it that PCs, Gore-Tex, and Teflon did not exist? How does one accurately account for that? Backward price measurement comparisons are simply hopeless because of a continuous array of new product and service offerings. Some even look at such quality improvements to make a claim that the CPI is actually overstated! The ranges for overstatement that I have seen are generally 1-2% and understatement by as much as 6-7%. Can a definition of inflation that includes enormously subjective measures possibly be of use to anyone?

Is a basket that relies solely on producer prices (PPI) the answer? If so how does one properly account for rising consumer prices but not producer prices and vice versa? Obviously this line of reasoning is hopeless.

The problem of accounting for stock market fluctuations is even worse for those in the "price increases caused by an increase in available currency and credit" camp because they have to decide if stock market prices are rising or falling because of general business conditions or because of expansion of money supply, risk taking, speculation, or time preferences.

A Look Back at the New Economy

Let's take a step back from all this madness and consider the decade of the 1990's. In the mid to late 1990's money supply rose dramatically by any commonly used measure yet the folks in the "price is all that matters" and "purchasing power" camps were not alarmed because the price of oil and gold and copper and computers were falling as Greenspan became a cheerleader for the "New Economy". Can a definition of inflation that ignores such problems possibly be right?

The fatal flaw made by Greenspan and the "price is all that matters" camp is that productivity improvements led by an internet revolution, along with global wage arbitrage and outsourcing to China and India, lowered costs on manufactured goods and kept the lid on wage increases in the manufacturing sector. Those factors all helped mask rampant inflation in money supply. The Greenspan FED further compounded the problem by injecting massive amounts of money to fight a mythical Y2K dragon that simply did not exist. Those monetary injections helped fuel a massive bubble in the stock market in 2000.

Everyone in the "price is all that matters/purchasing power" camp either has to ignore equity distortions or account for them by adding equity prices to the basket of goods and services. Either way is problematic.

The Role of Government

Those in the "because of" camp also need to take account of the fact that rising prices in a basket of goods and services as well as rising equity prices often happen because of "government imposed solutions to nonexistent problems".

One can even logically argue that government itself is the primary cause of rising prices. Look no further than Y2K, a Medicaid Bill that legislates against mass purchases of drugs, congressional action that impose tariffs on crops and lumber, congressional actions that prevents drug imports from Canada, builds bridges to nowhere in Alaska, and other such nonsense.

There are now more than 200 governmental bills designed to make housing affordable. The worst of the lot were bills authorizing creation of the GSEs (Fannie Mae and Freddie Mac). Lenders eventually figured out how easy it is to dump the riskiest loans onto those quasi government agencies. Credit standards then went downhill and home prices sky rocketed.

As reported in the Washington Post article FHA Alternatives To Subprime Loans Alphonso Jackson, Housing and Urban Development Secretary actually went so far as to send this message to private sub-prime lenders: "We need to reach out to African-American, Hispanic and other first-time buyers with better loan concepts, more flexible guidelines and quicker service. I am absolutely emphatic about winning back our share of the market that has slipped away to subprime lenders."

A government desire to win back market share from private lenders is most assuredly pure insanity. Indeed, promotion of the ownership society itself is at the very heart of this mess. Supposedly the government wants "affordable housing" yet it puts into practice anti-free market policies that absolutely ensure the opposite.

Let's briefly discuss Medicare/Medicaid. Government policies prohibit negotiation of bulk discounts. Those policies also prohibit imports from Canada and other nations willing to provide drugs at a cheaper cost. The most recent boondoggle is a process whereby recipients can only change providers once a year while providers can add or drop coverage with a mere 60 days notice. Someone signing up for benefits specifically because a needed drug was covered may find out after 60 days they have to eat the entire cost. What kind of sense does any of that make?

Somehow entitlement programs always have enormous cost overruns. The Medicare/Medicaid bill is no exception. Before the bill was even passed, its costs were known to be understated by at least $139 billion dollars. The Washington Post article White House Had Role In Withholding Medicare Data notes that Richard S. Foster, the government's chief analyst of Medicare costs was threatened with firing if he disclosed the true costs of the bill to Congress. The bill passed by an extremely slim margin. Had the true costs been disclosed it is doubtful the bill would have passed.

If you are looking for a source of inflation, there is no doubt that Greenspan, the FED, and government policies are all a huge part of the problem. What is interesting is that Greenspan is now finally starting to make sense for the first time in his entire career with his recent warnings about Fannie Mae, government spending, and trade deficits. For 18 years everyone listened to "The Maestro" even though most of what he said was totally unintelligible. Now the ultimate irony is that no one is paying attention just as he is finally starting to make some sense.

We will leave this matter for another time except to point out the following: The government and the FED are both always fighting some sort of mythical dragon. That is a huge problem over time.

A Use for the CPI

Let's now return to a question I asked earlier: Can a definition of inflation that includes enormously subjective measures such as the CPI possibly be of use to anyone? Actually it can, but not to any private citizen's benefit. The basket of goods and services as well as subjective measures of quality improvements can indeed be used by the government to underpay holders of inflation protected securities like TIPS, as well as understate cost of living adjustments to social security recipients.

How many believe the government's basket of goods and services is overweight computers and appliances and underweight heating bills, medical expenses, gasoline, insurance, and housing? Even if one believes the government was honest about the makeup of the basket, is the government biased about subjective measures of quality improvement of items in that basket? The problem of baskets and weightings is simply impossible to solve. The cynical will propose it is impossible to solve on purpose.

Money vs. Credit

Because of cart before the horse problems, basket selection problems, PPI vs. CPI problems, asset price problems, and government manipulation problems, we can easily discard the first 6 widely used definitions of inflation. That leaves us with a choice between the following:
  1. A net expansion of money supply
  2. A net expansion of money supply and credit
Given the current government policies that allow tremendous leverage via the fractional reserve lending, the most logical conclusion is that it is indeed necessary to distinguish between money and credit.

Fortunately the work in this area has already been accomplished by Austrian economist Frank Shostak. In The Mystery of the Money Supply Definition Shostak makes note of the difference between money supply and credit, while making a solid case that Money Supply (elsewhere called Austrian Money Supply or Money AMS) is Cash+demand deposits with commercial banks and thrift institutions+government deposits with banks and the central bank. The difference between Money AMS and other published "money supply" figures such as M1, M2, M3, or MZM is therefore either credit, over-counting, or pure nonsense.

Before making a final decision between the two remaining definitions let's first consider a real world example: Japan 1982-2004. Some argue that Japan never went through deflation. One basis for that argument is that "money supply" as measured by M1 never contracted over a sustained period. The other argument is that prices as measured by the CPI never fell much. Once again we have a flawed argument about consumer prices and a flawed argument that only looks at money and not credit.

Although Japan was rapidly printing money, a destruction of credit was happening at a far greater pace. There was an overall contraction of credit in Japan for close to 5 consecutive years. Property values plunged for 18 consecutive years. The stock market plunged from 40,000 to 7,000. Cash was hoarded and the velocity of money collapsed. Those are classic symptoms of deflation that a proper definition incorporating both money supply and credit would readily catch. Those looking at consumer prices or monetary injections by the bank of Japan were far off the mark.

Frank Shostak nicely describes the end of such economic booms in Making Sense of Money Supply Data:

As prices of financial assets begin to rise, in order to keep their growth momentum intact the money supply rate of growth must expand. Any slowdown in the money supply rate of growth will slow the growth momentum of financial assets' prices.

Once the rate of growth slows down false activities encounter trouble. Since the diversion of real resources toward these activities slows down, a fall in the money rate of growth strangles them. It follows then that rising growth momentum of money leads to an expansion in nonwealth generating activities (also known as an economic "boom") while a fall in growth momentum undermines false activities and results in an economic bust.


Note that it was a continued collapse in credit as opposed to a collapse in government monetary printing that eventually sealed the fate in Japan. The lesson to be learned from Japan is that once the ability and/or desire of consumers and corporations to take on more debt is reached, the party is over barring and out and out hyperinflationary expansion of money. For a discussion of Ben Bernanke's hyperinflationary "helicopter drop" solution to deflation, please see Robert Blumen's article Bernanke: Foreign Savings Glut Harms the US.

In practice, a helicopter drop of money would bail out consumers at the expense of the FED. Furthermore such actions would eventually destroy the FED's own power and wealth. Logic would therefore dictate that the helicopter drop threat would not be carried out in actual practice. No doubt there will be further endless debate on this subject, one way or another, until the final collapse is at hand.

Conclusions

The logical outcome of the above discussion is that a proper definition of inflation or deflation must be built on the foundation of a sound definition of money supply that distinguishes between money itself and credit. The definition should also ensure that the horse and the cart are in their proper places.

With the above in mind:
  1. Inflation is best described as a net expansion of money supply and credit.
  2. Deflation is logically the opposite, a net contraction of money supply and credit.
  3. Government mandated solutions to problems best left to the free market is the root cause of money supply expansion.
  4. With no enforcement mechanism such as a gold standard to keep things honest, and with no desire to raise taxes, governments simply approve programs with no way to fund them. The FED has been all too willing to play along by printing the money needed for those government programs. To make matters worse, the fractional reserve lending policies of the FED allows an even greater expansion of credit on top of the money printed. Eventually those actions result in a crack-up-boom and debasement of currency.
  5. Changes in "Purchasing power" required to buy a basket of goods and services can not be accurately measured because of the need to continuously add new products to the basket, because the measurement of quality improvements on existing products is too subjective, and because it is impossible to pick a representative and properly weighted basket of goods, services, and assets in the first place. Furthermore, such measurements are highly prone to governmental manipulation at private citizen expense. Endless bickering over the CPI numbers every month should be proof enough of these allegations.
  6. Measurement of equity price fluctuations poses a particularly difficult problem for those bound and determined to put the cart before the horse as well as those that think such assets belong in any sort of basket.
  7. Price targeting by the FED is doomed to failure because a representative basket of goods and services can not be created, because prices can not properly be measured, and because price targeting puts the cart before the horse.
  8. Expansion of money supply (typically to accommodate unfunded government spending) and expansion of credit (via GSEs, fractional reserve lending, and other unsecured debt issuance) are two of the biggest problems. Targeting the outcome (prices) can not possibly be the solution.
  9. Ludwig von Mises describes the endgame brought on by reckless expansion of credit: "There is no means of avoiding the final collapse of a boom brought about by credit (debt) expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit (debt) expansion, or later as a final and total catastrophe of the currency system involved."
  10. The FED should have been listening to Mises all along. Instead they have put their faith in "productivity miracles", "new paradigms", and their own hubris. Those actions have accomplished nothing other than delay the eventual day of reckoning.
Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/


Copyright 2009 Mike Shedlock. All Rights Reserved.
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