Hey Austrians, Where Is the Inflation?

Of all the criticisms that Austrian economists receive, this complaint is the most reasonable and legitimate of all. Many Austrian economists (so I’m told) have predicted that when Ben “The Bubble” Bernanke drastically inflated the money supply in response to the Great Recession in 2009, this would cause runaway inflation. Because this hasn’t happened, Austrian economics is 100% wrong and all fellow Austrians should go sit in the corner and let the Keynesians break some more windows for us.

This is the conventional wisdom we are told to believe, whether it’s from Facebook memes or from Paul Krugman and his ilk. If we are looking at inflation in its narrowest term, the purchasing power of a unit of currency, then no, we don’t see inflation. The problem with looking at an inflation index is the same problem as Keynesian economics: it aggregates all the important information away.

What is seen

Here are the actual inflation values as calculated by the Bureau of Labor Statistics (BLS). As you can see, inflation has been around 2%-3% for the past 14 years and these values would certainly make central bankers proud and they would pat themselves on the back for keeping inflation around 2%-3% each year. Rejoice, for inflation is solved! Prices are steady and all is well. But wait, wasn’t there a giant housing bubble that popped in 2008?

During the housing bubble, inflation was around 2%-3%, yet it completely wrecked our economy and the consequences of which still reverberate in our economy today in 2014. So the question is more than just why we don’t see runaway inflation. We should also be looking at more than just a single index number.

What is not seen

We must first start by recognizing the function of money. It is not used for direct exchange; we do not purchase money in order to directly use it to satisfy our wants. We don’t eat money nor use it as wallpaper in our house (if you do, please invite me over for dinner; send the limo). Its only use is for indirect exchange; we exchange for money in order to turn around and exchange it back for another good that we will use directly to satisfy our wants. Because everyone in a potential exchange may not desire what we possess, and vice versa, we use money to avoid this double coincidence of wants.

Purchasing power measures the amount of a monetary unit expressed in prices of commodities. For measuring inflation, the Bureau of Labor Statistics (BLS) calculates inflation rates based on a “basket” of selected commodities for the Consumer Price Index (CPI). The change in the total cost of this basket is then used to determine how much the purchasing power of money has changed.

This “basket” represents real assets, commodities that we use directly. What money represents is the claim to these real assets. Therefore, if claims to real assets are increasing while real assets remain the same, then we should see inflation. And this would be true, if our economy was a closed economy (didn’t trade with any other countries), if technology remained stagnant, if population remained stagnant, if the preference of people, firms, and banks to hold cash balances remained stagnant, and if taxes remained stagnant.

inflation1If all of these conditions held true, if claims to real assets would increase (say 20%), real assets would remain the same, and the purchasing power of these claims (money) would decrease. The ratio of money to real assets would increase from 1:1 to 1.2:1. That would look like this chart:

The problem with this simplistic logic is that none of these conditions are held true in the real economy. So then why don’t we see inflation?

Let’s look at possible reasons why inflation is not high in spite of a dramatic increase in the supply of money.

  1. Cash balances

The cash balances of people, banks, and businesses could be increasing (sitting on the money). This money is withheld from circulation as long as it sits and will not increase prices.

The Fed can inflate the money supply all it likes, but it cannot force people spend the new money; it can only encourage people, businesses, and banks to do so. If the people do not spend the new money, it is not introduced into the system and inflation cannot occur. Yet.

Suppose you have an income of $10,000 and you spend $9,000 on consumption or investment. This means that you now have $1,000 as a cash balance, that is, you keep 10% of your income as pocket money. Now, suppose the supply of money increases 10% and you receive new money proportional to the amount you have. Your income increases 10% from $10,000 to ($10,000)(1.1) = $11,000. But suppose you decide not to increase your consumption or investment despite the increase in your income. You will still spend $9,000 on consumption or investment and you will hold a cash balance of $2,000.

So long as you do not spend this new money, inflation will not affect price structure of the goods you buy. Although new money has been given to you, is has not been introduced into the economy to affect prices because the increase in the supply of money went directly to your cash balance. Inflation will not occur until your cash balance decreases to your former comparable level.

inflation3Your cash balance is used in case you need to buy something in the future. It is like a claim to real assets in the future. Increasing your cash balance is comparable to increasing claims to future real assets. In the chart, if the new money simply increases your cash balance, it will just be a future claim to real assets, and not affect prices now. The red box indicates what affects the present price structure, that is, future claims are not affecting present prices though the amount of money has increased.

Suppose the same situation, where your income increased is $11,000 due to inflation but now you decide to hold the same proportion of cash balance (that is, 10% of income). You now spend $9,900 and hold a cash balance of $1,100. The increase in your nominal spending causes producers to raise the prices of the things you buy, and in this way inflation works its way through the economy. Rather than sitting on the money, the amount you spend is increased, causing prices to rise.

Now that we have established how increased cash balances can prevent inflation from occurring, have people, businesses, and banks been increasing their cash balances? The answer is yes.

“U.S. companies outside of the finance industry are holding more cash on their balance sheets than ever, with $1.64 trillion at the end of 2013. That’s up 12 percent from the prior record in 2012…”

A lot of the “new” money is not being introduced into the economy. Instead, it is being held by companies as increased cash balances. So long as companies continue to increase their cash balances, some of the inflation will not be released until cash balances decrease and are spent for consumption.

  1. Trade deficit

Trade deficits allow us to “export” our inflation to other countries that hold our dollar. Once this money comes back to the U.S. then inflation will start showing up. The U.S. has a large trade deficit, meaning we are importing far more goods than we are exporting to other countries. The U.S. has been running trading deficits since the 1970’s, and here is the graph since 2000.

In 2013, the trade deficit was $476 billion. This means that foreigners have cash balances in American dollars that are not being spent on American goods to the tune of $476 billion, from 2013 alone. This is the same thing as individuals or businesses increasing their cash balances domestically. This money is being held rather than being spent on American goods. So far. Similar to cash balances, they are future claims and do not affect the present price structure.

At some point, American dollars will travel back to the U.S., whether by directly exchanging by purchasing more American exports or by some other indirect means. Once they do, that is when inflation will start to increase. If it is by exports, factors of production (input) will be more in demand for the exporting industries, raising prices of these factors and removing capital from non-exporting industries. There will be more competition for capital, which will see a rise in price, and price increases will gradually spread through the American economy as capital becomes more expensive.

  1. Technological advancesScreen Shot 2014-11-01 at 6.59.52 PM

Technological advances decrease the price of goods, allowing the savings to be spent on additional goods that we previously didn’t have. For example, just think about computers. Here is the price index of personal computers and peripheral equipment calculated by the BLS. Since 1999, the price of these things has dropped by about 85%.

What this means is that you now only need to spend $100 in 2009 for the same thing (or better!) what would have cost $700 ten years earlier. You have $600 extra now to spend on other things. The purchasing power of your income has increased because the same amount of money can buy more things to improve your standard of living. It’s not because your actual, nominal income has increased, but because the cost of living has decreased.

Inflation helps to reduce the advantages that are bestowed upon us by technological advances. Looking at the same computer example, suppose the Fed greatly inflated the money supply over this 10-year period (it actually did and still does). Suppose it was inflated so much that the purchasing power of a dollar decreased by 85%, that is, $7 in 1999 is now worth only $1 in 2009. Suppose also that you bought a computer in 1999 and a new one in 2009. To you, it appears that the cost of a computer and peripheral equipment has not changed. You spent $700 in 1999 for a computer and its equipment, and you spent the same amount of $700 on a computer and its equipment.

The cost of living should be decreasing and the purchasing power of a dollar should be increasing due to these advances. But inflation has stolen some of your income’s purchasing power. The nominal cost of a computer hasn’t risen so inflation seems stable. But inflation has taken the place of the advantages of technological breakthroughs. Without inflation, in 2009 you would have a new computer and peripheral equipment and $600 left over. With inflation, you now only have a computer and peripheral equipment with no money left over.

inflation4In the chart, the extra $600 would be spent on other real assets. This is represented as real asset growth. But as you can see, claims to real assets have increased due to inflation, and the price structure seems to have remained unchanged.

Of course, this is an exaggerated example simply to show how inflation robs you on this front. In reality, inflation has wiped out only some and not all savings in the cost of living (though you can’t blame them for lack of trying). Without monetary inflationary, the computer price index would have decreased more sharply, as money would have retained more of its purchasing power over the 10-year period, and the cost of living would have decreased to a greater extent.

This is just for one sector of the economy. Imagine how much cheaper products from other branches of the economy would be if their technological advances were allowed to actually lower the cost of living in the same proportion as costs saved. The more money that is created, the less advantage you derive from a lower cost of living due to technology.

Between the lines

All 3 of these reasons may explain why we don’t see a dramatic increase in the inflation index. But the greater problem is that inflation measures tell us nothing about whether or not capital is being allocated to the best employments to satisfy the most urgent needs of consumers, whether or not the consumers and the taxpayers are being robbed blind by the central bankers, and whether or not our economy is operating on a sustainable path and not just creating bubbles.

What are the answers to these questions? Monetary inflation coupled with artificially low interest rates only causes consumers to overconsume and investors to malinvest. Don’t think there are any bubbles? Let’s ask the monetary wizards at the IMF (who believe in unicorns, chupacabra, and Keynesian economics): IMF fears ultra-low interest rates are fueling assets bubbles. But don’t worry, inflation is low. Printing money does not create wealth; it robs the purchasing power from those who hold it.

So why is inflation still so low still? Cash balances and exports have not entered the American economy asking for redemption with American goods, but someday they will. Deflationary effects have also counteracted inflation.

Several economists from several different schools, including Keynes himself, soundly agree upon the evils of inflation:

“Inflation is taxation without legislation” – M. Friedman

“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments” – F. Hayek

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens” – J.M. Keynes

At least someone can benefit from inflation, because it’s certainly not the citizens.