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Inflation’s Not the Only Way Easy Money Destroys Wealth – Article by Frank Shostak

Inflation’s Not the Only Way Easy Money Destroys Wealth – Article by Frank Shostak

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The New Renaissance Hat
Frank Shostak
October 14, 2014
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The US Federal Reserve can keep stimulating the US economy because inflation is posing little threat, Federal Reserve Bank of Minneapolis President Kocherlakota said. “I am expecting an inflation rate to run below two percent for the next four years, through 2018,” he said. “That means there is more room for monetary policy to be helpful in terms of … boosting demand without running up against generating too much inflation.”

The yearly rate of growth of the official consumer price index (CPI) stood at 1.7 percent in August against two percent in July. According to our estimate, the yearly rate of growth of the CPI could close at 1.4 percent by December. By December next year we forecast the yearly rate of growth of 0.6 percent.

Does Demand Create More Supply?

It seems that the Minneapolis Fed President holds that by boosting the demand for goods and services — by means of additional monetary pumping — it is possible to strengthen economic growth. He believes that by means of strengthening the demand for goods and services the production of goods and services will follow suit. But why should that be so?

If by means of monetary pumping one could strengthen the economic growth then it would imply that — by means of monetary pumping — it is possible to create real wealth and generate an everlasting economic prosperity.

This would also mean that world wide poverty should have been erased a long time ago. After all, most countries today have central banks that possess the skills to create money in large amounts. Yet world poverty remains intact.

Despite massive monetary pumping since 2008, and the policy interest rate of around zero, Fed policymakers seem to be unhappy with the so-called economic recovery. Note that the Fed’s balance sheet, which stood at $0.86 trillion in January 2007 jumped to $4.4 trillion by September this year.

Production Comes Before Demand

We suggest that there is no such thing as an independent category called demand. Before an individual can exercise demand for goods and services, he/she must produce some other useful goods and services. Once these goods and services are produced, individuals can exercise their demand for the goods they desire. This is achieved by exchanging things that were produced for money, which in turn can be exchanged for goods that are desired. Note that money serves here as the medium of exchange — it produces absolutely nothing. It permits the exchange of something for something. Any policy that results in monetary pumping leads to an exchange of nothing for something. This amounts to a weakening of the pool of real wealth — and hence to reduced prospects for the expansion of this pool.

What is required to boost the economic growth — the production of real wealth — is to remove all the factors that undermine the wealth generation process. One of the major negative factors that undermine the real wealth generation is loose monetary policy of the central bank, which boosts demand without the prior production of wealth. (Once the loopholes for the money creation out of “thin air” are closed off the diversion of wealth from wealth generators towards non-productive bubble activities is arrested. This leaves more real funding in the hands of wealth generators — permitting them to strengthen the process of wealth generation (i.e., permitting them to grow the economy).

Artificially Boosted Demand Destroys Wealth

Now, the artificial boosting of the demand by means of monetary pumping leads to the depletion of the pool of real wealth. It amounts to adding more individuals that take from the pool of real wealth without adding anything in return — an economic impoverishment.

The longer the reckless loose policy of the Fed stays in force the harder it gets for wealth generators to generate real wealth and prevent the pool of real wealth from shrinking.

Finally, the fact that the yearly rate of growth of the CPI is declining doesn’t mean that the Fed’s monetary pumping is going to be harmless. Regardless of price inflation monetary pumping results in an exchange of nothing for something and thus, impoverishment.

Frank Shostak is an adjunct scholar of the Mises Institute and a frequent contributor to Mises.org. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. See Frank Shostak’s article archives.

This article was published on Mises.org and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.

Heterogeneity: A Capital Idea! – Article by Sanford Ikeda

Heterogeneity: A Capital Idea! – Article by Sanford Ikeda

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The New Renaissance Hat
Sanford Ikeda
June 26, 2014
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When Thomas Piketty’s Capital in the 21st Century was released in English earlier this year it sparked vigorous debate on the issue of wealth inequality. Despite the prominence of the word in the title, however, capital has not itself become a hot topic. Apparently none of his defenders have taken the opportunity to explore capital theory, and, with a few exceptions, neither have his critics.

To prepare to read Mr. Piketty’s book I’ve been studying Ludwig Lachmann’s Capital and Its Structure, which, along with Israel M. Kirzner’s Essay on Capital, is among the clearest expositions of Austrian capital theory around. A hundred years ago the “Austrian economists”—i.e. scholars such as Eugen von Böhm-Bawerk who worked in the tradition of Carl Menger—were renowned for their contributions to the theory of capital. Today capital theory is still an essential part of modern Austrian economics, but few others delve into its complexities. Why bother?

Capital is Heterogeneous

 

Among the Austrians, Böhm-Bawerk viewed capital as “produced means of production” and for Ludwig von Mises “capital goods are intermediary steps on the way toward a definite goal.” (Israel Kirzner uses the metaphor of a “half-baked cake.”)  Lachmann then places capital goods in the context of a person’s plan: “production plans are the primary object of the theory of capital.” You can combine capital goods in only a limited number of ways within a particular plan. Capital goods then aren’t perfect substitutes for one another. Capital is heterogeneous.

Now, mainstream economics treats capital as a homogenous glob. For instance, both micro- and macroeconomists typically assume Output (Q) is a mathematical function of several factor inputs, e.g. Labor (L) and Capital (K) or

Q = f(L,K).

In this function, not only is output homogenous (whether we’re talking about ball-bearings produced by one firm or all the goods produced by all firms in an economy) but so are all labor inputs and all capital inputs used to produce them. In particular, any capital good can substitute perfectly for any other capital good in a firm or across all firms. A hammer can perfectly replace, say, a helicopter or even a harbor.

On the other hand, capital heterogeneity implies several things.

First, according to Mises, heterogeneity means that, “All capital goods have a more or less specific character.” A capital good can’t be used for just any purpose:  A hammer generally can’t be used as a harbor. Second, to make a capital good productive a person needs to combine it with other capital goods in ways that are complementary within her plan: Hammers and harbors could be used together to help repair a boat. And third, heterogeneity means that capital goods have no common unit of measurement, which poses a problem if you want to add up how much capital you have:  One tractor plus two computers plus three nails doesn’t give you “six units” of capital.

Isn’t “money capital” homogeneous? The monetary equivalent of one’s stock of capital, say $50,000, may be useful for accounting purposes, but that sum isn’t itself a combination of capital goods in a production process. If you want to buy $50,000 worth of capital you don’t go to the store and order “Six units of capital please!” Instead, you buy specific units of capital according to your business plan.

At first blush it might seem that labor is also heterogeneous. After all, you can’t substitute a chemical engineer for a pediatrician, can you? But in economics we differentiate between pure “labor” from the specific skills and know-how a person possesses. Take those away—what we call “human capital”—and then indeed one unit of labor could substitute for any other. The same goes for other inputs such as land. What prevents an input from substituting for another, other than distance in time and space, is precisely its capital character.

One more thing. We’re talking about the subjective not the objective properties of a capital good. That is, what makes an object a hammer and not something else is the use to which you put it. That means that physical heterogeneity is not the point, but rather heterogeneity in use. As Lachmann puts it, “Even in a building which consisted of stones completely alike these stones would have different functions.” Some stones serve as wall elements, others as foundation, etc. By the same token, physically dissimilar capital goods might be substitutes for each other. A chair might sometimes also make a good stepladder.

But, again, what practical difference does it make whether we treat capital as heterogeneous or homogenous? Here, briefly, are a few consequences.

Investment Capital and Income Flows

 

When economists talk about “returns to capital” they often do so as if income “flows” automatically from an investment in capital goods. As Lachmann says:

In most of the theories currently in fashion economic progress is apparently regarded as the automatic outcome of capital investment, “autonomous” or otherwise. Perhaps we should not be surprised at this fact: mechanistic theories are bound to produce results that look automatic.

But if capital goods are heterogeneous, then whether or not you earn an income from them depends crucially on what kinds of capital goods you buy and exactly how you combine them, and in turn how that combination has to complement the combinations that others have put together. You build an office-cleaning business in the hopes that someone else has built an office to clean.

There’s nothing automatic about it; error is always a possibility. Which brings up another implication.

Entrepreneurship

 

Lachmann:

We are living in a world of unexpected change; hence capital combinations, and with them the capital structure, will be ever changing, will be dissolved and re-formed. In this activity we find the real function of the entrepreneur.

We don’t invest blindly. We combine capital goods using, among other things, the prices of inputs and outputs that we note from the past and the prices of those things we expect to see in the future. Again, it’s not automatic. It takes entrepreneurship, including awareness and vision. But in the real world—a world very different from the models of too many economists—unexpected change happens. And when it happens the entrepreneur has to adjust appropriately, otherwise the usefulness of her capital combinations evaporates. But that’s the strength of the market process.

A progressive economy is not an economy in which no capital is ever lost, but an economy which can afford to lose capital because the productive opportunities revealed by the loss are vigorously exploited.

In a dynamic economy, entrepreneurs are able to recombine capital goods to create value faster than it disappears.

Stimulus Spending

 

As the economist Roger Garrison notes, Keynes’s macroeconomics is based on labor, not capital. And when capital does enter his analysis Keynes regarded it the same way as mainstream economics: as a homogeneous glob.

Thus modern Keynesians, such as Paul Krugman, want to cure recessions by government “stimulus” spending, without much or any regard to what it is spent on, whether hammers or harbors. (Here is just one example.)  But the solution to a recession is not to indiscriminately increase overall spending. The solution is to enable people to use their local knowledge to invest in capital goods that complement existing capital combinations, within what Lachmann calls the capital structure, in a way that will satisfy actual demand. (That is why economist Robert Higgs emphasizes “real net private business investment” as an important indicator of economic activity.)  The government doesn’t know what those combinations are, only local entrepreneurs know, but its spending patterns certainly can and do prevent the right capital structures from emerging.

Finally, no one can usefully analyze the real world without abstracting from it. It’s a necessary tradeoff. For some purposes smoothing the heterogeneity out of capital may be helpful. Too often though the cost is just too high.

Sanford Ikeda is an associate professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism.
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This article was originally published by The Foundation for Economic Education.
Where Is the Inflation? – Article by Mark Thornton

Where Is the Inflation? – Article by Mark Thornton

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The New Renaissance Hat
Mark Thornton
January 30, 2013
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Critics of the Austrian School of economics have been throwing barbs at Austrians like Robert Murphy because there is very little inflation in the economy. Of course, these critics are speaking about the mainstream concept of the price level as measured by the Consumer Price Index (i.e., CPI).

Let us ignore the problems with the concept of the price level and all the technical problems with CPI. Let us further ignore the fact that this has little to do with the Austrian business cycle theory (ABCT), as the critics would like to suggest. The basic notion that more money, i.e., inflation, causes higher prices, i.e., price inflation, is not a uniquely Austrian view. It is a very old and commonly held view by professional economists and is presented in nearly every textbook that I have examined.

This common view is often labeled the quantity theory of money. Only economists with a Mercantilist or Keynesian ideology even challenge this view. However, only Austrians can explain the current dilemma: why hasn’t the massive money printing by the central banks of the world resulted in higher prices.

Austrian economists like Ludwig von Mises, Benjamin Anderson, and F.A. Hayek saw that commodity prices were stable in the 1920s, but that other prices in the structure of production indicated problems related to the monetary policy of the Federal Reserve. Mises, in particular, warned that Fisher’s “stable dollar” policy, employed at the Fed, was going to result in severe ramifications. Absent the Fed’s easy money policies of the Roaring Twenties, prices would have fallen throughout that decade.

So let’s look at the prices that most economists ignore and see what we find. There are some obvious prices to look at like oil. Mainstream economists really do not like looking at oil prices, they want them taken out of CPI along with food prices, Ben Bernanke says that oil prices have nothing to do with monetary policy and that oil prices are governed by other factors.

As an Austrian economist, I would speculate that in a free market economy, with no central bank, that the price of oil would be stable. I would further speculate, that in the actual economy with a central bank, that the price of oil would be unstable, and that oil prices would reflect monetary policy in a manner informed by ABCT.

That is, artificially low interest rates generated by the Fed would encourage entrepreneurs to start new investment projects. This in turn would stimulate the demand for oil (where supply is relatively inelastic) leading to higher oil prices. As these entrepreneurs would have to pay higher prices for oil, gasoline, and energy (and many other inputs) and as their customers cut back on demand for the entrepreneurs’ goods (in order to pay higher gasoline prices), some of their new investment projects turn from profitable to unprofitable. Therefore, you should see oil prices rise in a boom and fall during the bust. That is pretty much how things work as shown below.

As you can see, the price of oil was very stable when we were on the pseudo Gold Standard. The data also shows dramatic instability during the fiat paper dollar standard (post-1971). Furthermore, in general, the price of oil moves roughly as Austrians would suggest, although monetary policy is not the sole determinant of oil prices, and obviously there is no stable numerical relationship between the two variables.

Another commodity that is noteworthy for its high price is gold. The price of gold also rises in the boom, and falls during the bust. However, since the last recession officially ended in 2009, the price of gold has actually doubled. The Fed’s zero interest rate policy has made the opportunity cost of gold extraordinarily low. The Fed’s massive monetary pumping has created an enormous upside in the price of gold. No surprise here.

Actually, commodity prices increased across the board. The Producer Price Index for commodities shows a similar pattern to oil and gold. The PPI-Commodities was more stable during the pseudo Gold Standard with more volatility during the post-1971 fiat paper standard. The index tends to spike before a recession and then recede during and after the recession. However, the PPI-Commodity Index has returned to all-time record levels.

High prices seem to be the norm. The US stock and bond markets are at, or near, all-time highs. Agricultural land in the US is at all time highs. The Contemporary Art market in New York is booming with record sales and high prices. The real estate markets in Manhattan and Washington, DC, are both at all-time highs as the Austrians would predict. That is, after all, where the money is being created, and the place where much of it is injected into the economy.

This doesn’t even consider what prices would be like if the Fed and world central banks had not acted as they did. Housing prices would be lower, commodity prices would be lower, CPI and PPI would be running negative. Low-income families would have seen a surge in their standard of living. Savers would get a decent return on their savings.

Of course, the stock market and the bond market would also see significantly lower prices. Bank stocks would collapse and the bad banks would close. Finance, hedge funds, and investment banks would have collapsed. Manhattan real estate would be in the tank. The market for fund managers, hedge fund operators, and bankers would evaporate.

In other words, what the Fed chose to do ended up making the rich, richer and the poor, poorer. If they had not embarked on the most extreme and unorthodox monetary policy in memory, the poor would have experienced a relative rise in their standard of living and the rich would have experienced a collective decrease in their standard of living.

There are other major reasons why consumer prices have not risen in tandem with the money supply in the dramatic fashion of oil, gold, stocks and bonds. It would seem that the inflationary and Keynesian policies followed by the US, Europe, China, and Japan have resulted in an economic and financial environment where bankers are afraid to lend, entrepreneurs are afraid to invest, and where everyone is afraid of the currencies with which they are forced to endure.

In other words, the reason why price inflation predictions failed to materialize is that Keynesian policy prescriptions like bailouts, stimulus packages, and massive monetary inflation have failed to work and have indeed helped wreck the economy.

Mark Thornton is a senior resident fellow at the Ludwig von Mises Institute in Auburn, Alabama, and is the book-review editor for the Quarterly Journal of Austrian Economics. He is the author of The Economics of Prohibition, coauthor of Tariffs, Blockades, and Inflation: The Economics of the Civil War, and the editor of The Quotable Mises, The Bastiat Collection, and An Essay on Economic Theory. Send him mail. See Mark Thornton’s article archives.

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Copyright © 2013 by the Ludwig von Mises Institute. Permission to reprint in whole or in part is hereby granted, provided full credit is given.

Not Enough Inflation? – Article by Tyler Watts

Not Enough Inflation? – Article by Tyler Watts

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The New Renaissance Hat
Tyler Watts
July 15, 2012
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Two wrongs may not make a right, but a second dose of poison might just cure the first dose. That’s at least what Paul Krugman, America’s most prominent left-wing economic pundit, is saying about an untapped remedy for our economic woes. In his April 5 New York Times column, “Not Enough Inflation,” Krugman repeated his claim that “a bit more inflation would be a good thing, not a bad thing.”

If you’re wondering how progressively higher prices for everyday goods could help any household get ahead economically, let alone contribute to overall economic recovery, you’re in good company. As all econ-principles students know, inflation is caused by an increase in the supply of money relative to money demand. The increase in consumer goods prices—that’s how the layman defines and experiences inflation—is really just a symptom of the reduced purchasing power of money caused by the increase in its quantity. The higher prices for all goods in turn mean lower real incomes for consumers—which is all of us—not to mention that inflation is also typically symptomatic of the boom-bust business cycle and can cause significant widespread economic damage. In its most severe forms, inflation can wipe out people’s monetary wealth and bring commerce to a halt.

But smart guys like Professor Krugman aren’t mere monetary cranks. They know that high inflation is economically dangerous. What they’re asking for is just a small, temporary dose of fresh money to inject some new life into the economy. There is a kernel of truth to this inflationary prescription. As the Scottish philosopher David Hume explained in his 1752 essay Of Money, prices for different kinds of goods react differently to new money entering the economy. Generally speaking, commodities or consumer goods prices will rise faster than wages. So for a manufacturing entrepreneur, for instance, who employs many workers, inflation will cause output prices (revenue) to increase relative to wages (costs), bringing an increase in profits that will induce an increase in output. Therefore, in Hume’s terms, an increase of money “must first quicken the diligence of every [entrepreneur], before it increase the price of labor.”

This “sticky wages” effect is what economists like Hume, John Maynard Keynes, and Krugman have in mind when advocating inflationary stimulus. Krugman also notes that “parts of the private sector continue to be crippled by the overhang of debt accumulated during the bubble years,” and that “modest inflation . . . by eroding the real value of that debt . . . [would] help promote the private-sector recovery.” So higher inflation not only increases the demand for labor, but can also help clean up companies’ and individuals’ balance sheets, giving them the ability to ramp up their hiring and spending. What’s not to love about this miracle elixir?

There are two big problems with inflationary stimulus. The first involves the process dynamics of the market economy. The inflationists tend to omit the rest of the story, which involves the long-run effects of new money. New money will eventually increase all prices—even wages—meaning the stimulus effect can only be temporary. For if entrepreneurs read the price increases not as mere inflation, but higher demand for their products (as the inflationists hope), they are liable to make investments to expand their production capacity. Once the inflation effect peters out, once rising wages eventually push profits back down, they find that extra production is no longer profitable. The expansion can’t be sustained without more inflationary stimulus.

In a rising inflation environment, moreover, people will eventually come to anticipate further price increases. Workers demand upward wage adjustments in advance, and entrepreneurs anticipate rising costs and thus scale back their expansion plans. Once people catch on to inflationary stimulus in this fashion, larger and larger money injections (that is, higher inflation rates) are needed to merely maintain output levels. At some point, the high, rising, and volatile inflation rate itself becomes a drag on the economy. Miscalculation of next year’s, or even next month’s, inflation rate could spell disaster for entrepreneur and worker alike. As inflation heats up, it can actually drag investment down, as people seek to shelter their wealth in “sterile” assets like gold. Inflation, instead of a stimulus factor, becomes a source of economic confusion and frustration. Iconic images of people hauling wheelbarrow loads of money to buy a loaf of bread in post-World War I Germany remind us of the potential economic turmoil of unchecked inflation. This of course is not what Krugman has in mind, but we should not forget that the mightiest river begins as a trickle.

The second big problem with inflation is a moral one. Along with causing economic confusion, inflation redistributes wealth. The key fact here, again, is that not all prices rise immediately when new money enters circulation. People who are first to receive the new money get to spend it before prices go up. Those last in line see prices go up before their own incomes do. Inflation also redistributes wealth from lenders to borrowers, as Krugman indicated, by reducing the real value of debt. But Krugman conveniently ignores the corresponding fact that, whenever a borrower’s real debt burden is eased, a lender’s asset value is eroded. Thus to use inflation as a partial bailout for borrowers is to harm lenders and investors. This is happening already—even at “mild” inflation rates that are too low for Krugman’s tastes, real returns on investments like bank CDs are driven into negative territory.

Through these redistributions of purchasing power, inflation acts like a tax: a tax on savers, on investors, on those at the very end of the monetary policy food chain. Ironically for Progressives like Krugman, this inflation tax arguably hits the poor and uneducated hardest. Educated, economically sophisticated people know the warning signs of inflation and know how to shelter their assets—as attested by the flurry of gold bullion dealers’ ads on cable news and AM radio. The poor are much more likely to be wage earners whose incomes tend to lag inflation, or pensioners who, even with annual cost-of-living adjustments, can still see consistent reductions in their purchasing power.

Nonetheless, Krugman and the inflation party don’t understand the free-market camp’s arguments against inflation. He accuses us of “obsessing” over inflation, while he thinks the Fed should focus on curing unemployment. Even conceding that inflation can provide a temporary, halting employment stimulus, the objection remains strong. It comes down to the fact that inflation is a big lie—or, should we say, a million little lies, because inflation distorts all prices and thereby hinders their crucial function of giving entrepreneurs and workers the correct information and incentives on which to make the best economic decisions. Inflation’s promises of faster growth and greater wealth are illusory. Like alcohol or drug abuse, every high begets a crash that demands larger and larger doses to maintain the effect. Inflation is a dangerous medicine that stands to do the patient more harm than good.

Tyler Watts is an assistant professor of economics at Ball State University and the winner of the 2012 Beth A. Hoffman Memorial Prize for Economic Writing.

This article was published by The Foundation for Economic Education and may be freely distributed, subject to a Creative Commons Attribution United States License, which requires that credit be given to the author.