(This item originally appeared at Forbes.com on September 17, 2022.)
Over the past year, there has been a deluge of commentary about “inflation.” This has included my recent book coauthored with Steve Forbes and Elizabeth Ames, appropriately titled: Inflation. In that book, knowing the ruts that economists have found themselves trapped in for decades, we anticipated the likely course of discussion, and outlined some alternatives. Let’s see how things have been stacking up.
On the book’s cover itself, we anticipated that even the word “inflation” — which I have recently been putting in quotes — is a term of some confusion. This has turned out to be the case. People seem as confused as ever.
The term arises from popular speech, and tends to become a grab-bag or stew-pot of all kinds of things that could conceivably cause the Consumer Price Index to rise. In the book, we began our analysis by segregating causes and effects that are inherently nonmonetary in nature, and basically amount to some kind of supply/demand issue in real-world goods and services; and those that are inherently monetary, and basically amount to mismanagement of the currency, and do not arise from any supply/demand issue in the real economy.
The study of economics itself has tended to cleave along these lines. The Keynesian-flavored economists tend to focus on the supply/demand issues, often summed up on a macro scale as “aggregate supply and aggregate demand.” Their frameworks inherently tend to assume a currency of stable value. Keynes himself was not so naive. But, after Keynes’ death in 1946, his various acolytes, hemmed in by the Bretton Woods gold standard system that mostly managed to keep currency values stable, tended to simplify their inquiries to nonmonetary factors alone. Thus, they were befuddled when their core assumptions — stable currency value — were undone after Nixon ended the Bretton Woods gold standard in 1971.
This oversight by the Keynesians was remedied by the Monetarists, who took the opposite stance, that all “inflation” was inherently monetary. This was a needed correction, but the Monetarists then ignored all the nonmonetary, supply/demand factors that actually do influence prices. Thus, today, all the economists are wrong half the time; or, they are half-wrong all the time.
This one-or-the-other mentality is summarized by the ongoing debate about the “Phillips Curve,” which goes something like this: A stronger economy (lower unemployment) leads to higher prices. Actually, Phillips himself argued that lower unemployment (less supply/more demand for labor) leads to higher wages. Not exactly a surprising conclusion, and in fact it does work in the real world. Robust economies often have rising prices, and weak economies (recessions) often have falling prices. It is possible to have a strong economy with falling prices, and a weak economy with rising prices, but nevertheless the basic Phillips Curve assertions often work out in real-life experience.
More Monetarist-flavored economists, or anyway those with a better awareness of currency issues, have a different argument: If “inflation” is basically a monetary phenomenon (as it often is), whether you call that an excess of money supply or a decline in the value of the currency, then it is stupid to say that a healthy economy or low unemployment causes an excess of currency quantity, or a decline in currency value. This is not just semantics. Because, if you start saying that a healthy economy with low unemployment is a monetary problem, then you must also tell the Federal Reserve that they must blow up the economy whenever it threatens too much health or too high employment. Heaven forbid that wages rise! This seems dumb, and in fact, it is. But, if “inflation,” which in practical policymaking terms means changes in the CPI, is “always a monetary phenomenon,” and the CPI goes up, then what other option is there?
In our book, we took the radical stance that: Sometimes prices go up or down for nonmonetary reasons, and sometimes for monetary reasons. Sometimes, both at the same time.
I know, amazing insight. Who would have thought it?
But, I think we can now see that, as boringly obvious as this is, the commentariat falls far short of comprehending it.
The outcome of both these lines of thinking, Keynesian and Monetarist, is the same: The solution to “inflation” is recession. This doesn’t sound like much of a “solution” to me. I call it the “three wrongs make a right” hypothesis. In today’s terms, Wrong #1 is: some kind of supply/demand issue, like suppressed automobile production, housing shortage, or the outcome of really intense government deficit spending in 2020-2021 (or “aggregate demand” as the Keynesians often argue). The solutions are obvious: make more cars, make more houses, don’t spend so much money.
Wrong #2 is: the genuinely overaggressive central bank response in 2020, which did indeed lead to a decline in currency value (about 30% vs. gold) just as one would expect, and the corresponding increase in prices that results. The solution is: Don’t Do That. At the very least, keep the currency from falling further. Maybe, allow it to rise a bit to correct past error.
These sound like two good things: Make more cars, built more houses, and have a stable, reliable currency. Add some lower taxes and less onerous regulations, and you should have an economic boom, lower unemployment, and higher wages as a result. This is basically what Reagan did in the 1980s, and it worked.
Instead, the “solution” we hear about is Wrong #3: More unemployment. Because, if the problem is “aggregate demand” (Keynesian for “buying stuff”) then we should have a recession to cause less buying and thus less demand. If the problem is monetary, then we need some kind of monetary restriction (either through interest rates or quantity statistics), until the CPI (or maybe nominal GDP) falls to an acceptable level. Both of these basically amount to a recession.
On the monetary side, the goal is not the CPI or NGDP, but Stable Value. The way this was achieved in the past — for nearly two centuries until 1971 — was to link the dollar’s value to gold. The IMF actually bans countries from doing this today. But, it is still a common policy, among the 100+ countries that officially tie their currencies to some external standard of value, most commonly the USD or EUR.
Even with a currency of idealized stable value, this would not produce an unchanging CPI. The CPI might go up, down, or whatever, due to a variety of nonmonetary factors, just as the Keynesians describe. But, that’s fine. Prices are supposed to go up and down. The value of the currency is supposed to be stable.
The Federal Reserve is not quite so stupid. Actually, it seems to have repented its excesses of 2020, and has maintained the value of the USD roughly stable vs. gold around $1800 for about two years now — probably not an accident. Just as Paul Volcker did in the 1980s (after abandoning Monetarism in 1982), the Federal Reserve today seems to want to keep the USD loosely — way too loosely for my taste — stable vs. gold.
But, this has never lasted for long. Sooner or later, “something happens,” most likely a recession since that is now official policy, and we are back to “easy money,” probably accompanied by “fiscal stimulus,” just as we saw in 2020. These bad habits are hard to break. We’ve gone around and around this cycle for the last fifty years, the Floating Fiat era, and the result is that the dollar’s value vs. gold has declined by about 98%, or 50:1. It now takes 50x more dollars to buy an ounce of gold than it did during the Kennedy administration. This is not a healthy trend, and it might get worse.
Unfortunately, the debate over “inflation” today is about as bad as it has ever been. Nonmonetary problems of supply and demand require nonmonetary solutions. The basic solution for a currency is simple: Keep the currency stable in value. The institutionalized and formalized version of this principle is the gold standard system.
