(This item originally appeared at Forbes.com on July 20, 2018.)
Whenever the economy has been doing well for a while, we have a discussion about: “Does growth cause inflation?” Some people say yes; others say no. I think they are both wrong.
It’s important because we don’t want the Federal Reserve to squash the boom with some kind of “tight” policy if it doesn’t have to. But, if inflation is a real problem, we also want the Federal Reserve to do something about it.
The difficulty lies in the meaning of the word “inflation” – or rather, the lack of meaning. The word is commonly used in a vague, imprecise way to describe a variety of situations that are actually quite different. In Gold: The Once and Future Money (2007), I adopted Ludwig von Mises’ convention of using the word “inflation” to mean situations of monetary distortion only. It’s better when words have only one meaning. But, most people, including economists, don’t do things this way.
Let’s say that the Mexican peso has a foreign exchange value of twenty pesos per U.S. dollar. Some time later, the peso is at 40/dollar. We might expect that some freely traded good that cost $20 would also cost 400 pesos; and later, $20/800 pesos. The real value of the item is unchanged. The increase in the nominal price, in terms of pesos, was entirely due to the decline in the value of the peso vs. the dollar. In general, we don’t want central banks to allow currencies to fall in value by half like this. It has a lot of unpleasant consequences. So, we insist that central banks avoid this kind of outcome, perhaps by taking a “tight” stance if necessary.
This increase in the price of the item, in terms of pesos, was entirely due to monetary changes – the change in the value of the peso. It didn’t have anything to do with “growth” in Mexico. Along these lines, you can’t stop this kind of “monetary inflation” with various sorts of measures that prevent growth. For example, you can’t stop this kind of inflation by raising taxes. Then you would just end up with monetary inflation and also high taxes, which can be very unpleasant. Two wrongs don’t make a right.
But, other people take the word “inflation” to mean something like: any increase in the official Consumer Price Index, or whatever price index might be in favor at the time. Economic growth does tend to cause a rise in the CPI, even in the absence of monetary factors. In a briskly growing economy, some prices are going up; and some prices are going down. Usually, prices for manufactured goods are going down. But, wages, rents, most asset values, and prices for services are generally going up. On balance, an index like the CPI tends to rise.
During the 1950s and 1960s, the dollar and the yen were linked to gold – the Bretton Woods gold standard, in which the dollar’s value was stabilized at $35/oz. The yen was worth an unchanging 360/dollar, or 12,600/oz. In the 1960s, Japan was enjoying a spectacular economic boom – one of the best of any country in the twentieth century. During that decade, the measured CPI in Japan rose at a 5.5% annualized rate. (The U.S. CPI rose at 2.6%.) This increase in the CPI in Japan – “inflation” – was, it appears, wholly nonmonetary in nature. It caused no problems whatsoever, and was simply a statistical aftereffect of the amazing economic growth of that time. Wages rose dramatically, and the unemployment rate hovered around 1.1%-1.6% through the decade. The Bank of Japan did nothing to prevent it, and no unpleasant consequences resulted. With the advantage of fifty years of hindsight, nobody has identified any problem resulting from this high “inflation” in Japan in the 1960s.
You can have as much of this nonmonetary growth-related “inflation” as you want, with no negative consequences. Between 1985 and 1995, the Hong Kong dollar was linked to the U.S. dollar with a reliable currency board. Measured CPI “inflation” during that decade was 8.6% per annum in Hong Kong, and 3.6% in the U.S. Like Japan in the 1960s, this higher “inflation” in Hong Kong, compared to the U.S., was related to the high growth in Hong Kong during that time. It caused no problems whatsoever. Rising wages are the whole point of economic growth.
Now you can see the problem with dictates like Milton Friedman’s “Inflation is always and everywhere a monetary phenomenon.” Except when it isn’t, like in Japan and Hong Kong. Can you imagine what today’s central banks, which commonly follow something like a 2% “inflation target,” would do when faced by 5.5% or 8.6% “inflation” year after year for a decade? They would do something very stupid and destructive.
People who understand that “inflation” can be caused by monetary distortion often overlook the fact that CPI increases can come about due to growth effects. They assume that, in the absence of monetary factors (declining currency value), the measured CPI “inflation” would be very low, perhaps around 0%-1%. This is not true.
Now it gets more complicated. For a long time, and continuing today, people have had the idea that central banks can “manage the economy” using various funny-money tricks. When unemployment is high, they take an “easy money” stance. They hope that the resulting monetary distortion will cause people to make investments and hire employees, that they would not do in an environment of monetary stability. For example, let’s say the Mexican peso fell in value from 20/dollar to 40/dollar. The real value of wages in Mexico would also fall, and Mexican exporters would become more “competitive” due to low wages. This might lead to more employment, and investment in business. Also, existing peso debt burdens would be lightened, because they would be paid back in a currency of less value. The real price of all kinds of goods and services would decline (because prices are denominated in a currency of falling value), with the result that there might be more “demand” for them. An “artificial boom” can result, much loved by certain governments who have been playing these games for centuries.
Eventually, this “easy money” has to come to an end, or the economy will eventually topple into full hyperinflation. When the economy is doing better, the central bank can lay off the “monetary stimulus,” and adopt a more cautious stance. That’s the idea. Thus, “growth” is taken as a sign that there has been more than enough “monetary stimulus.” What actually happens is that the economy is continually crippled by the monetary distortion caused by floating currencies, and central banks going from “easy” to “tight” and back again, all the while fooling around with interest rates and in general making a nuisance of themselves.
You can’t really figure these things out by looking at the CPI in isolation. If the currency’s value is stable – as in Japan and Hong Kong – then you can have as much growth as you like, and it’s fine. If the currency is declining in value (as in our Mexico example), then the central bank should prevent that by taking the necessary steps to make the currency stable again. You don’t try to solve a nonmonetary problem, like unemployment, with a monetary “solution” that involves currency distortion.
In the end, you want the Magic Formula: Low Taxes for a healthy economy and low unemployment; Stable Money to prevent economic distortion from monetary effects. With the combination of the Trump tax cuts, and the “Yellen Gold Standard,” we are pretty close to that ideal right now. Then, you don’t have to worry about the CPI, just as Japan and Hong Kong didn’t worry about it.
Today, the value of the dollar has been pretty strong, against gold, commodities or foreign currencies. There is no evidence that any rises in the CPI in the U.S. have been due to the monetary distortion caused by falling currency value. It’s a harmless growth effect. Sit back and enjoy it, including higher wages.
Rather, I think that we should encourage even more growth (and even higher wages) in the U.S. with another round of tax reform, this time focused on much lower tax rates for individual income. The result might be even higher “inflation” as shown by the CPI. If we are really aggressive about it, we might even approach the 5.5% “inflation” of Japan in the 1960s. That would be wonderful.
