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Need we fear inflation?

By Thomas E. Brewton
web posted March 12, 2007

Contrary to the popular understanding, higher wage rates and higher oil prices do not cause inflation. They are symptoms of the real danger.

News reports express concern that the tightening labor market and increasing oil prices will lead to increased inflation. This is an upside-down view of reality.

Inflation is nothing more nor less than an increasing ratio of money to available goods and services.

Higher prices – rising wages or higher oil prices, for example – result from two things.

First is excessive money supply creation and the resulting excessive amount of bank credit pumped into the economy.

Second is a change in the balance between supply and demand. Wages will rise whenever increasing business activity necessitates hiring more workers, with the requisite skills and experience, than are available in the needed locations. Oil prices will rise because demand exceeds current or anticipated supplies in the locations where oil is needed.

In either case, price increases are the result, not a cause.

Free markets are automatic and self-correcting. If wages rise, businesses will decide either that the wage costs of increased production will leave too little profit to warrant hiring more workers, or the higher wages will induce more people to enter the labor market to meet the increased demand. In either case, wages will level off or decline.

This means that Congress's raising the minimum wage or imposing threatened price controls on gasoline and heating oil do nothing whatever to curb underlying inflation. Raising the minimum wage just lowers the point at which businesses will stop hiring more workers. Gasoline and heating oil price controls, as we learned again when President Nixon tried them, will simply divert oil to other markets without price controls.

This also means that Keynesian economic orthodoxy, as employed by the Federal Reserve Board, is still as misguided as ever. Keynes believed that business production and investment in expanded capacity could be supported only by welfare-state transfers to consumers, whose spending would lever up economic activity and employment. This remains sacred dogma for liberal Republicans and liberal Democrats.

The problem is that government spending precedes increased production. The rising ratio of money supply to goods imparts an inflationary bias.

Moreover, unlike the automatic, free-market mechanism that reduces demand to supply, or increases supply to meet demand, government propensity to spend has no built-in limit, nor has ill-informed voters' desire for more spending.

Debasing the dollar via excessive government spending, in historical precedent, will be checked only when other nations refuse to accept more dollars in payment for imports and begin demanding payment in some other, sounder currency. We are moving closer to that point.

Only once in the post-World War II era has the Fed dealt realistically with the real cause of inflation: excessive increases in the money supply.

In the early 1980s, confronting our Great Society stagflation with inflation in the teens, the Fed's new Chairman Paul Volcker acted on the economic reality that inflation is no more than too much money chasing too few goods and services, that the way to curb inflation is to control the money supply.

In a PBS interview in more recent years, Mr. Volcker described it this way:

Well, the Federal Reserve had been attempting to deal with the inflation for some time, but I think in the 1970s, in past hindsight, anyway, [it] got behind the curve. It's always hard to raise interest rates.

"......we adopted an approach of doing it perhaps more directly, by saying, "We'll take the emphasis off of interest rates and put the emphasis on the growth in the money supply, which is at the root cause of inflation" - too much money chasing too few goods …- "so we'll attack the too-much-money part of the equation and we will stop the money supply from increasing as rapidly as it was."

Interest rates rose to very high levels in the short run, but inflation was broken and stagflation ended.

This was a classic illustration of supply and demand economics. When the supply of money is decreased, the price of money – interest rates – will rise until consumers are unwilling to pay the costs of additional consumption, or businesses' costs rise enough to make added production unprofitable. Either way, equilibrium between demand and supply is restored and prices (including interest rates, the price of money) stabilize.

Since then, unfortunately, the Fed has reverted to the old, completely discredited Keynesian faith that government planners can fine-tune the economy via government spending and interest rate manipulation in order to attain full employment, price stability, and steady GDP growth.

Rather than stabilizing the money supply, the Fed now indirectly raises short term interest rates. The effect of higher interest rates works its way backwards, from the Fed to businesses and consumers, making production and consumption more costly.

This is upside-down. Interest rates in a free market, following the law of supply and demand, will rise in reaction to increased production that necessitates increased borrowing by businesses.

Instead, the Fed attempts to forestall increased production by raising interest rates. The risk is that the Fed's arbitrary rate-setting will either precipitate a recession, or allow inflation to get out of hand.

Finding the correct balance point, about which former Fed chairman Alan Greenspan often worried, requires more analytical brain power than socialist state-planners possess. With 300 million consumers and many thousands of businesses independently anticipating Fed policy and future economic conditions, the world's largest aggregation of supercomputers would be inadequate for the task, even if there were enough analysts to input all the data on a real-time basis.

By default, the Fed has to make an informed guess about where interest rates ought to be. Which is why we read that some Fed governors are worried about mounting inflationary pressures, while the Fed Board votes to keep rates unchanged and Chairman Bernancke tells us that "core" inflation is still not too worrisome.

Meanwhile, the real source of inflation – the money supply – continues its unchecked growth as the Fed finances ballooning government expenditures.

Keynesian and other liberal-Progressive-socialistic theories, as history demonstrates, do not work as advertised, because they are founded on a false theory of human nature. The underlying assumption is that, after government taxes and spending have equalized income among economic, ethnic, and social classes, the populace will happily settle into homogenized equality, every person working to the best of his ability, taking only what he needs.

Needless to say, in real life, since the New Deal when Presidents and Congresses got the bit in their teeth and realized that unceasing spending buys votes, there has been no turning back. We wallow in the spoils system, with the Fed debasing the currency to "pay" for it. ESR

Thomas E. Brewton is a staff writer for the New Media Alliance, Inc. The New Media Alliance is a non-profit (501c3) national coalition of writers, journalists and grass-roots media outlets. His weblog is The View From 1776.

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