On Inflationary Central Bank Policy (ABCT / etc):

Economics Economics Questions
1

My friend and I are involved in an ongoing debate as to whether or not inflation can have a net benefit.

He buys into the idea that inflationary monetary policy causes harm, but wonders whether or not inflation might spur greater economic growth than would otherwise occur. He points out that inflation has averaged (I’m going to fudge the numbers here) 3% annual growth for the last 80 years, while economic growth has averaged 10% (that’d be expressed nominally, I suppose). The point here being that economic growth has been great and that inflation has been comparatively small.

  • He accepts the idea that inflationary policy causes the boom / bust cycle
  • He recognizes that the natural tendency for commodities through the last eighty years should have been a fall in price.
  • He’ll concede that the advances in communications, infrastructure, and technology that couldn’t have done anything other than lead to economic growth.
  • He also accepts that a possible endpoint of this all may be the breakdown of the international fiat monetary system, and that booms / busts tend to lead towards anti-capitalist sentiment and possible economic restriction.
  • He also acknowledges the conclusions of the Austrian Business Cycle Theory – that some of the growth during a period of inflationary growth is MAL-investment that otherwise would not occur.

I felt like my answer that there’re a limited number of things which can be utilized by economic agents for economic advantage at a given time and that misallocation carries the opportunity cost of not using said finite things in their most efficient way (i.e. towards producing things that people want, for instance) was a good one. Is it conceivable, though, that inflationary policy increases the scope of things (labor, capital goods) which may be called into productive use? Can inflationary monetary policy open up new markets? I intuitively say no – that those things are fixed (at least at any given point in time), and that their availability will be based on restrictions by the state (i.e. the Chinese labor market is only as available as the Chinese government allows it to be).

What I’m looking for here is a logical argument to disprove this idea, that inflationary growth can mean greater positive (as in good) growth, since the pragmatic arguments against inflationary policy are clear. Is there a deductive argument that says that inflation doesn’t lead to increased growth?

2

My specialty is destroying support, so I shall start by commenting that he has no statistical support for saying that inflation helps economic growth. To point out that growth has been higher than inflation is post hoc ergo propter hoc at its absolute worst. Additionally, historically the correlation between economic growth and inflation has been negative. For example, according to inflation (measured as increase of prices at the end of the half century above those at the beginning, so a doubling of prices is 100% inflation) was 105% from 1800-1850 (total), 0.1%(!) from 1850-1900, 186% from 1900-1950, and 598% from 1950 to 2000. According to The Annual Real and Nominal GDP for the United States, 1790 - Present, growth in real GDP was 571% from 1800-1850, 756% from 1850-1900, 373% from 1900-1950, and 452% from 1950-2000. The most striking figure is that the two half-centuries with lowest economic growth had the highest inflation, and vice-versa.

Inflation over time cannot open up markets, although incidental inflation can (the infamous long and short-term Phillip’s graphs). Remember that any argument associating inflation with long-term economic growth must prove that it increases productivity over long periods of time, and not simply when first started.

Making a deductive argument is more difficult due to the general impossibility of proving a universal negative, but it should be better possible to prove that the lack of inflation helps growth. I do not have time to delve into it deeply right now, but I shall make a few observations for now:

Economic growth is furthered by increases in productivity. Productivity is increased either when capital is increased, technology is bettered, labor skills are improved, or the incentive to work is increased. Any of the first three factors require economic input to increase, while the last the incentive to work is presumably strongest when people have a strong sense of value in their wages. Consequently, the incentive to work will be strongest during times of low inflation. Additionally, the higher inflation is, the lower the future value of saved earnings (assuming that real interest rates fall with an increase in inflation, which I believe to be true but cannot prove), so higher inflation will discourage working beyond consumption. Regarding capital, technology, and skills, these require economic output, and therefore have a higher potential value when all economic resources are used efficiently. Assuming that low inflation increases efficiency due to a higher knowledge of market conditions, then low inflation leads to a higher potential increase in productive capacity. What I am unprepared to investigate, however, is whether inflation increases or decreases the percentage of that potential increase that is put towards future production as opposed to present consumption.

I fear that this is not what you wanted, but I hope that something within can help.

3

I’ll read what you’ve written tomorrow (I’m off to bed shortly), I just thought I’d share something that he and I realized (well…remembered) today.

He was arguing from a capital availability standpoint – perhaps capital is more widely available in an inflationary system. Y’know – artificially low-interest rates would seem to maybe make capital more widely available for investments. As we discussed it though we recalled that inflation is something that gets factored into interest rates. In its absence, rates would fall (in Gary North’s words, the “inflation premium” would disappear and ultimately go negative due to deflation), i.e. capital would be readily available.

Thanks for your reply - I’ll check it out tomorrow.

4

Great stuff - just some nice statistics to match my intuitive sense of the history of the US Economy.

Thanks!

5

Not that I necessarily know what I’m talking about (I’m just a fan of the Austrian School, and economics is just a recent hobby of mine), but doesn’t price inflation take place, and therefore get factored in a good deal of time after monetary expansion?

On the other hand, inflating the money supply, even if it didn’t cause a rise of interest rates, wouldn’t make capital more available. Creating more money doesn’t create more goods (capital or otherwise), that’s why you have price inflation as a result in the first place.

Isn’t factoring inflation into interst rate is just a natural reaction to the fact that capital isn’t more available?

6

There is no deductive proof that can be offered because inflation is just an increase in supply. It is impossible to deduce that an increase in the supply of money will not lead to a better fulfillment of the demands of consumers, just like it is impossible to deduce that an increase in the supply of corn will not lead to a better fulfillment of the demands of consumers. But if the supply of any product is increased without an increase in effective demand, then it will take resources away from the production of goods and services for which there is effective demand. And this will not produce a net benefit.

In principle there is no way to differentiate between the arguments: 1) There can be a net benefit from increasing the supply of money. 2) There can be a net benefit from increasing the supply of sewage. The problem with your friend’s argument only occurs if he argues that inflation inevitably produces a net benefit. In this case, benefit can be maximized only by producing the highest possible rates of inflation. Theoretically, if it is the case that inflation always produces a net benefit, all resources should be moved from their current endeavor and funneled into the production of money. This would cause death. So now, your friend would have to delineate the point at which inflation moves from being beneficial to being harmful.

Specifically, there is no way to deduce that inflation cannot have a net benefit. And there is no way to prove that inflation MUST produce a net benefit. Your friend is right. Inflation, provided there is effective demand, will lead to a net benefit. The question Austrian Economists ask is, “Why is the free market an inadequate source of monetary inflation?”

7

Actually, it’s almost impossible to avoid deducing it, if done correctly.

The reason capitalism works is that pricing is the most efficient mechanism for weighing supply, demand, efficiency, new ideas, et cetera.

It is a mathematical fact that causing a shift in pricing like inflation or deflation will distort that communication. It does not hit all prices instantly, in exactly the same proportion, but spreads around unevenly, causing some prices to change more than others.

This has to be harmful to the overall economy.

It’s as if you were arguing that adding a randomizing factor to a power steering wheel, so it would constantly be shifting a bit from where you put it, can’t be deductively proven to be harmful to your driving. Sure, you can claim that MAYBE at some moment the random factor will actually steer better than you do, but overall it’s just got to be worse.

And the same is true for steering the economy.