Gold bugs like Ron Paul like to argue that economists have conflated inflation with price inflation. Paul says that inflation is, by definition, growth in the money supply. Some thoughts based on this perspective:
- By this analysis, assuming a 1-to-1 direct relationship between an increase in the supply of money and an increase in inflation (see below for why this is silly), we would have experienced an annual rate of inflation of about 1.5 percent per year in the postwar period if our money was gold. This is the rate at which the global gold supply has expanded. Also, while expanding at a fairly stable rate, the supply of gold has sometimes unexpectedly changed. We would have inflation and uncertainty in Ron Paul’s utopia.
- Price inflation has been quite low for the past decade. Since 2000, the CPI has gone up about 2.5 percent per year on average. Core inflation, which excludes food and energy, has gone up 2 percent per year over this span. The Fed thinks core inflation is a more appropriate measure for their purposes because they can control it more directly than they can headline inflation.
- Food and energy prices have been extremely volatile. Gold standard advocates such as Paul argue that such volatility is caused by the Fed; meanwhile, the Fed maintains that the shocks on these prices are outside of their control. Here’s a chart of oil price pressures over the past two decades; you decide which story is more plausible. (A similar chart could be made for food prices.)
- There are libraries of ink spilled over the relationship between money supply and inflation, but two things are clear. There is a relationship between how much money is in an economy and how much things cost, but that relationship is not very easy to track because price changes are influenced by many things other than the supply of money. Gold standard advocates understand this, but their rhetoric often makes it seem as though the Fed is the lone villain behind price inflation. Observe, then, the relationship between the quantity of money in the economy and price changes since 1980.
- Price inflation in the wake of QE-1 and QE-2 has risen from near zero, but inflation in general has been especially low, something that gold bugs, with their sole emphasis on the relationship between money supply inflation and price inflation, have yet to explain.
Time horizon is wrong. Looking at only the last 20 years tells us nothing. Look at CPI from 1800 to 2010 to get a true idea of when price inflation started.
Apparent ‘price inflation’ includes both money supply inflation by the Fed, and also market price deflation by consumers who are indicating that they no longer wish to pay the same prices as they did during the boom years. That is, if not for a huge influx of new money, the price of many goods in the CPI might be drastically reduced.
Read ‘America’s Great Depression’ by Murray Rothbard. Money supply inflation was used to counteract real deflation caused by productivity increases. This increase in the money supply lead entrepreneurs to start businesses to make things people didn’t want at prices they weren’t willing to pay, resulting (predictably) in the 1929 market crash. Rather than let bad companies go out of business to free up factory machines and workers, the government printed more money, allowing the mal-investments to limp on for decades.
Today we have the same issue. There are a massive number of companies (especially in the banking and housing sectors) who are charging prices no one is willing to pay for things nobody wants. Of course these companies are downsizing and refusing to hire while they wait for the storm to blow over. While they wait, they tie up available cash with business restructuring loans, and they tie up capital in idled factories.
We need interest rates to rise, so that companies that are not productive (as measured subjectively by the market) can be put out of business. We need prices of goods to fall (to their true subjective market values) to allow entrepreneurs to know what things people really want, and what prices they are willing to pay, so they can meet those needs. The only way to acquire money should be by producing something worth trading for, or by borrowing from someone else who has. The Federal Reserve is antithetical to prosperity because is antithetical to these three basic laws of economics.
Unfortunately, there a number of problems with these graphs. First of all, graphing only percent change is deceptive in that it shows only immediate shocks to indicators, rather than long-term changes. Saying that changes in energy prices result from factors outside the feds control because major events cause spikes is a bit like arguing that cancer doesn’t kill people because we see spikes in death rates during wartime.
To be sure, prices are greatly influenced by things having nothing to do with the money supply (e.g., the invasion in Iraq). But, over the long haul, it’s hard to dispute the relationship between an increasing money supply and the devaluing of currency. (See this graph from the St. Louis Fed, for instance) As M1 and M2 have risen, so has CPI.
Finally, we must understand that Austrians (such as Paul) do not argue that the Fed’s actions result in immediate market volatility. Instead, they believe that expansion of the money supply leads to mal-investment, which eventually results in volatility when the “house of cards” propped up by cheap credit falls down (e.g., the savings and loan crisis, the dot com bust, the housing market crash, etc.). No matter how often the Fed claims that market volatility is a result of things outside its control (such as a bubble in the housing market), the reality is that the Fed encourages the behaviors which cause those events to occur.