Economic Growth Is Not Inflationary

Gary North - March 30, 2018

Let's get our definition straight: inflation is a rising money supply.

Inflation is not rising prices. That is the Keynesians' definition. It has become the common definition in the media.

I invoke the words of my friend Henry Hazlitt. In 1964, he wrote a well-timed book, What You Should Know About Inflation. He began it as follows.

No subject is so much discussed today — or so little understood — as inflation. The politicians in Washington talk of it as if it were some horrible visitation from without, over which they had no control — like a flood, a foreign invasion, or a plague. It is something they are always promising to "fight" — if Congress or the people will only give them the "weapons" or "a strong law" to do the job.

Yet the plain truth is that our political leaders have brought on inflation by their own money and fiscal policies. They are promising to fight with their right hand the conditions brought on with their left.

Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit. In fact, inflation is the increase in the supply of money and credit. If you turn to the American College Dictionary, for example, you will find the first definition of inflation given as follows:

Undue expansion or increase of the currency of a country, especially by the issuing of paper money not redeemable in specie.

In recent years, however, the term has come to be used in a radically different sense. This is recognized in the second definition given by the American College Dictionary:

A substantial rise of prices caused by an undue expansion in paper money or bank credit.

Now obviously a rise of prices caused by an expansion of the money supply is not the same thing as the expansion of the money supply itself. A cause or condition is clearly not identical with one of its consequences. The use of the word "inflation" with these two quite different meanings leads to endless confusion.

The word "inflation" originally applied solely to the quantity of money. It meant that the volume of money was inflated, blown up, overextended. It is not mere pedantry to insist that the word should be used only in its original meaning. To use it to mean "a rise in prices" is to deflect attention away from the real cause of inflation and the real cure for it.

Why is this definition so important? First, because it is analytically accurate. The Austrian theory of the business cycle depends on it. Second, because it keeps us from believing government officials and Keynesian economists who try to hide the crucial fact from us: the Federal Reserve System is responsible for rising prices. The free market economy is not the cause. Hazlitt continues:

It is true that a rise in prices (which, as we have seen, should not be identified with inflation) can be caused either by an increase in the quantity of money or by a shortage of goods — or partly by both. Wheat, for example, may rise in price either because there is an increase in the supply of money or a failure of the wheat crop. But we seldom find, even in conditions of total war, a general rise of prices caused by a general shortage of goods. Yet so stubborn is the fallacy that inflation is caused by a "shortage of goods," that even in the Germany of 1923, after prices had soared hundreds of billions of times, high officials and millions of Germans were blaming the whole thing on a general "shortage of goods" — at the very moment when foreigners were coming in and buying German goods with gold or their own currencies at prices lower than those of equivalent goods at home.

To use the word inflation to mean "a rise in prices" is to deflect attention away from the real cause of inflation and the real cure for it.

What of shortages of goods and services because of a war? Some prices rise: prices of goods related to war production. But this draws money away from other lines of production. These prices fall. Hazlitt explained.

The rise of prices in the United States since 1939 is constantly being attributed to a "shortage of goods." Yet official statistics show that our rate of industrial production in 1959 was 177% higher than in 1939, or nearly three times as great. Nor is it any better explanation to say that the rise in prices in wartime is caused by a shortage in civilian goods. Even to the extent that civilian goods were really short in time of war, the shortage would not cause any substantial rise in prices if taxes took away as large a percentage of civilian income as rearmament took away of civilian goods.

An extract from his book is posted on the website of the Mises Institute here. Or order it here.

Incredibly, in our day we see this explanation of rising prices: a growing economy. This is imbecilic. Rising output means a rising quantity of goods and services. This means "more goods chasing after money." It means lower prices, not higher prices. This statement is on Investopedia, a popular site for investors.

Over time, the growth in GDP causes inflation, and inflation begets hyperinflation. Once this process is in place, it can quickly become a self-reinforcing feedback loop. This is because in a world where inflation is increasing, people will spend more money because they know that it will be less valuable in the future. This causes further increases in GDP in the short term, bringing about further price increases.

On the EconomicHelps site, we read this:

Inflation caused by economic growth

Typically, higher inflation is caused by strong economic growth. If Aggregate Demand (AD) in an economy expands faster than aggregate supply, we would expect to see a higher inflation rate. If demand is rising faster than supply this suggests that economic growth is higher than the long run sustainable rate of growth.

Consider the words of Ian Webster. I have no idea who he is. I hope no one else does, either.

Is inflation caused by economic growth?

Short answer: yes.

Long answer: inflation is a staple of a healthy economy, and contrary to what you may think, it's not a bad thing. In fact, inflation is normal in a healthy, growing economy - and an economy without inflation will encounter problems.

Economic growth causes inflation

First, supply and demand increases the cost of goods. In a fast-growing economy, demand is higher than supply. This means that the cost of good will naturally increase. The result is that the same goods cost more over time. In other words, inflation occurs.

Second, higher wages. Unemployment drops as more people find work in a high-growth economy. Across-the-board increase in wages generally results in higher inflation.

The problem here is the definition of inflation: rising prices in general. But this ought to raise the question: "Why are prices in general rising? More to the point, how are prices in general rising?

One reason: falling production due to a war. The money supply stays the same -- "that'll be the day!" -- but the supply of consumer goods is falling. Prices rise: "the same amount of money is chasing fewer goods." But this does not mean that there has been a failure of the free market economy. It means that the government is intervening in the economy to pay for the war. It is shifting production away from the free market. In short, government intervention is causing the rise in prices.

There may be a general fall in production. This has happened only during one decade out of the last 20: the 1930's. In the Great Depression, production fell. But the price level also fell.

In what way can a rising economy produce price inflation? Those who argue that this is possible never discuss what should be obvious: "the same amount of money is chasing more goods." Prices will steadily fall. This is made clear by Frank Shostak, an Austrian School analyst.

The price of a good is the amount of dollars paid per unit of this good. So with all things being equal, an increase in the amount of dollars in the economy must lead to a general increase in prices of goods and services. Now, when we talk about economic growth, we mean an increase in the production of goods and services, i.e., an expansion in real wealth. Obviously then, for a given amount of money an increase in economic growth means a greater amount of goods and services, which must lead to a decline and not an increase in the prices of goods and services in general. (We now have more goods for the same amount of dollars.)

In the month when the recession of 2008-9 bottomed, the Federal Open Market Committee issued a press release.

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The FOMC was using a cost-of-production theory of inflation. Because there are unemployed resources -- "economic slack -- said the Committee, "inflation will remain subdued." The FOMC has an odd definition -- conveniently unstated -- of "subdued."

Today, the economy is still experiencing price inflation at 2% per annum. The FOMC has raised the rate it pays on excess reserves deposited with the FED by commercial banks. It pays this out of its own income, but then it will not return this money to the Treasury in January. So, taxpayers are funding this transfer of money to commercial banks. This is neither inflationary nor deflationary. The monetary base has been constant since mid-2014. The FOMC adopted tight money in mid-2014.

So, all the talk about a change in policy by the FOMC is poppycock. The FOMC changed its policy over three years ago. Economic growth continued. Price inflation continued.

Can anyone explain this? Not that I have seen. But this much is sure: there has been increasing economic growth, prices rising at 2% per annum, and exceedingly low interest rates.

If the Federal Reserve System would stop paying commercial banks with taxpayers' money, and then shut down, we would have more liberty. We would not have more inflation. Inflation is a rising money supply. At present, in terms of FOMC policy, we do not have inflation.