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What is the right inflation target?

Adapted from my recent Facebook post:

This article on Mises.org is disappointing (Daniel Lacalle, “Price Inflation Slowed to 3 Percent. That’s Still Far Too High,” Mises Wire (July 24, 2023). I guess it’s a blessing they seem to have disabled comments. Because this would be my comment:

This is not how Austrians think—at least, not Misesian-Rothbardians. The title gives it away: “Price Inflation Slowed to 3 Percent. That’s Still Far Too High.” As if there is a desired inflation rate—say, zero percent (in nominal terms).

And this line: “Inflation is caused by the constant increase in the quantity of currency in circulation well above real demand.”

But (relative) price inflation is caused by any increase in the supply of money, regardless of the “demand” for money. In a fixed supply or relatively fixed supply money system, then an increase in the demand for money simply causes interest rates to rise. No need to find or print more money. Money is not wealth, so increasing its supply cannot increase wealth, it can only shift-it around, that is, redistribute it, and waste resources on mining as well.

From what I can tell, the author seems to think the problem is nominal price inflation. I.e., that zero percent should be the target. After all “Inflation is caused by the constant increase in the quantity of currency in circulation well above real demand.”

And this is also how freebankers think. They think you need more money when there is real demand for it (see my post “The Great Fractional Reserve/Freebanking Debate“). The Austrian view is that if you have a fixed money supply that’s always good enough (see: Mises; Rothbard; see my posts “Comments on Block and Barnett on the Optimum Quantity of Money” and “Walter Block on Money as a Sui Generis Good“).

If we had a fixed or mostly fixed money supply, there would be negative price inflation, that is, not zero percent, but negative: price deflation. That is, everyone holding money would become richer every day, as the purchasing power of their money increased in tandem with economy-wide productivity.

In other words, a zero nominal price inflation that is caused when you inflate the money supply just enough to “meet demand,” whatever this voodoo means, is still inflationary—in relative or real terms (which is all that matters). If there would be 5% price deflation with a fixed money supply, then even if you increase the money supply at ~5% to “meet demand,” so that price inflation is nominally zero, you still have a real net inflation of about 5%, which is manifested by various negative effects, such as redistribution of wealth (and possibly others like: Cantillon effects and business cycle effects, not to mention the waste of mining new money (assuming some physical commodity like gold is the money)).

For example, the author writes: “Three percent annual price inflation for ten years is a loss of purchasing power of 34 percent.” But this is only in nominal terms. If you assume there would be (say) 5% real growth in a non-inflationary environment, then a 3% nominal price inflation is more like an 8% relative price inflation. So you lose way more than 34% purchasing power over 10 years, in real terms (which is all that matters).

In my view, the problem is not nominal price inflation; it is real price inflation, which means relative to what it would have been.

(I wrote a letter about this to The Economist when I was in grad school, but they of course did not publish it. See “Unpublished Letter to The Economist on Inflation, and others.”)

Essentially, once you realize money is a sui generis good and is not itself wealth (like normal goods are), then you realize that increasing its supply can never increase wealth, and also, there is no market failure in a free market having a purely fixed money supply, that an expanding money supply (expanding in response to “demand”) “fixes.” I am not saying there “ought to be” a fixed money supply, just that it would be more ideal. I am not saying that voluntary increases in money supply in a free market is a violation of any property rights; but it is a cost of having a real-world money that can be inflated (even to a small degree), and this cost is manifested as waste in mining and as redistribution of wealth (which we see as relative price inflation). The cost is worth paying, generally, in order to have the benefits of a perfect money.

But especially when we are talking about the current state-managed money system, to say that 3% nominal price inflation is “too high” without saying what it’s too high relative to implies that zero percent (or some number lower than 3% that is what you would get when the supply expands to accommodate “real demand” for money—say, 1%? Or… whatever the freebankers predict a fractional-reserve freebanking system would give us?).

If instead you recognize that, especially in our current fiat/central bank system, any increase in the dollar money supply causes relative inflation, you would not say 3% is “too high”—you would say that the problem is the inflation of the money supply (dollars) and thus whatever relative price inflation this causes, is the real manifestation of the problem.

For example, suppose the Fed adopts a policy of inflating the dollar by 2% per year, at a steady, constant rate. If we assume an economy that grows at, say, 3% in real terms, this would result in something like a 1% price deflation every year. This would be good! But it would still be relative/real inflation because we would have had 3% price deflation. The 2% money supply inflation is still robbing consumers of ~2% purchasing power every year. Hey, guess what, even this compounds over 10 years!

Moreover, at least when this money supply inflation is being caused by the central bank (the fed) via fractional reserves and fiat money, even if the money supply inflation rate rate is low (say, 2%) and results in a negative nominal price inflation (say, a 1% deflation rate), it still would give rise to the business cycle, which destroys wealth and capital and thus lowers the overall average rate of growth (say, it’s 3% instead of 5%).

So, again, the problem is not that 3% nominal inflation is “too high.” Any degree of real relative price inflation is “too high,” especially if it’s caused by the central bank, and this money inflation causes both redistribution of wealth plus impoverishes us by causing the business cycle.

Thus this is the problem, not 3% nominal price inflation, and the solution is not to target a lower observable or visible price inflation “number,” but to attack the cause of it, which is the fiat centralized money system and fractional reserve banking. IMHO.

{ 1 comment… add one }
  • Jule Herbert July 27, 2023, 2:41 pm

    But the “liquidity trap”; you are obliged to explain why people would just hoard their money until everything went to hell.

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