Saturday , April 20 2024
Home / SNB & CHF / Krugman: Low Unemployment Causes Inflation, Not Monetary Expansion

Krugman: Low Unemployment Causes Inflation, Not Monetary Expansion

Summary:
In an article in the New York Times on March 27, 2018, Paul Krugman argues that economists who believe increases in money supply cause inflation are wrong. According to Krugman, the key factor that sets inflation in motion is unemployment. While a decline in the unemployment rate is associated with an increase in the rate of inflation, an upsurge in the unemployment rate is associated with a decline in the rate of inflation.Krugman believes inflation is about general increases in the prices of goods and services, which we suggest is a flawed definition. To ascertain what inflation really is, we must establish how this phenomenon emerged, tracing it back to its historical origin.The Essence of InflationInflation is an act of embezzlement. Historically, inflation

Topics:
Frank Shostak considers the following as important: , ,

This could be interesting, too:

Vibhu Vikramaditya writes Navigating the Slippery Slope: How Hoover’s Interventions Paved the Way for the Great Depression

Ryan McMaken writes Frédéric Bastiat Was a Radical Opponent of War and Militarism

Douglas French writes Millennials: In Costco We Trust

Joseph T. Salerno writes What Fed “Independence” Really Means

In an article in the New York Times on March 27, 2018, Paul Krugman argues that economists who believe increases in money supply cause inflation are wrong. According to Krugman, the key factor that sets inflation in motion is unemployment. While a decline in the unemployment rate is associated with an increase in the rate of inflation, an upsurge in the unemployment rate is associated with a decline in the rate of inflation.

Krugman believes inflation is about general increases in the prices of goods and services, which we suggest is a flawed definition. To ascertain what inflation really is, we must establish how this phenomenon emerged, tracing it back to its historical origin.

The Essence of Inflation

Inflation is an act of embezzlement. Historically, inflation originated when a country’s ruler, such as a king, would force his citizens to give him all their gold coins under the pretext that a new gold coin was to replace the old one. In the process, the king would falsify the content of the gold coins by mixing them with some other metal and return diluted gold coins to the citizens.

Murray Rothbard wrote, “More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of ‘pounds’ or ‘marks,’ but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.”

Because of the dilution of the gold coins, the ruler could now mint a greater number of coins and pocket for his own use those extra coins. What was now passing as a pure gold coin was in fact a diluted gold coin. As a result of the increase in the number of coins that masquerade as pure gold coins, prices in terms of coins now go up (more coins are being exchanged for a given amount of goods).

Note that we have an inflation (expansion) of coins. Because of inflation, the ruler can engage in an exchange of nothing for something, diverting resources from citizens to himself.

On the gold standard, the technique of abusing the medium of the exchange became much more advanced by banks that were providing storage for gold and issuing receipts unbacked by gold. Inflation, therefore, means an increase in the number of receipts not backed by gold, yet masqueraded as the true representatives of the money proper, gold.

The holder of unbacked receipts can now engage in an exchange of nothing for something. Because of the increase in the number of receipts (inflation of receipts), we now also have a general increase in prices in terms of receipts. The increase in prices emerges because of the increase in receipts that are not backed by gold, and the holders of unbacked receipts divert goods to themselves without making any contribution to the production of goods.

In the modern world, money proper is no longer gold but rather fiat money. Hence, inflation in this case is an increase in the stock of money. Unlike monetarists who say that the increase in the money supply causes inflation, we are saying that inflation is the increase in the money supply.

So, it seems that our Nobel laureate, instead of discussing inflation, actually is referring to its possible symptoms, which are price increases. As pointed out earlier, inflation is embezzlement. Ludwig von Mises wrote,

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call “inflation” the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business.

Once the proper definition of inflation is obliterated and inflation is viewed as general increases in prices, then all sorts of explanations of what causes these increases are possible.

By means of statistical correlation, Krugman asserts that a fall in the unemployment rate is an important driving factor of inflation. Hence, on this logic, policy makers must carefully watch the unemployment rate and decide whether it has reached the point where it could trigger an increase in the rate of inflation. We suggest that using statistical correlations as the basis of a theory means that “anything goes.”

For example, assume that a high correlation is established between the income of Mr. Jones and the rate of growth in the consumer price index. The higher the rate of increase of Mr. Jones’s income, the higher the rate of increase in the consumer price index. Therefore, we could easily conclude that in order to exercise control over the rate of inflation, the central bank must carefully watch and control the rate of increases in Mr. Jones’s income. This example is no more absurd than correlating the unemployment rate with the rate of increases in prices as Krugman does.

Contra Krugman, a low unemployment rate does not cause a general rise in the prices of goods and services and an economic overheating labeled as inflation. Regardless of the rate of unemployment, as long as every increase in expenditure is supported by production, no “overheating” can actually occur. The overheating emerges once expenditure increases without being backed up by production, a situation that emerges when the money stock is increasing.

Krugman also argues that the Fed’s inflation target of 2 percent is too low. He argues that the Fed should aim at a higher inflation target, which amounts to even more monetary pumping. Furthermore, Krugman believes that the Fed should not tighten its interest rate stance since this could push the US economy into a liquidity trap.

If Krugman were to define inflation correctly, he would realize that a tighter stance would be required to eliminate various bubble activities that undermine the process of wealth generation. Contrary to Krugman, a liquidity trap is the outcome of loose monetary policy of the Federal Reserve. This stance, which weakens the process of real savings generation, results in either a stagnant or a shrinking pool of real savings. Without an expanding pool of real savings, the illusion that the central bank can grow the economy is shattered.

Conclusion

By means of statistical correlation, Krugman asserts that a decrease in the unemployment rate helps drive inflation. Using this logic, policy makers must carefully watch the unemployment rate and decide if it has reached the point where it could trigger an increase in the rate of inflation, which is another way of saying, “anything goes.”

However, a low unemployment rate does not cause prices of goods and services to rise and create economic overheating. Regardless of the rate of unemployment, as long as every increase in expenditure is supported by production, no “overheating” can actually occur. Overheating emerges once expenditure increases without being backed up by production, a situation that emerges when the money stock increases.


Tags: ,
Frank Shostak
Frank Shostak is an Associated Scholar of the Mises Institute. His consulting firm, Applied Austrian School Economics, provides in-depth assessments and reports of financial markets and global economies. He received his bachelor's degree from Hebrew University, master's degree from Witwatersrand University and PhD from Rands Afrikaanse University, and has taught at the University of Pretoria and the Graduate Business School at Witwatersrand University.

Leave a Reply

Your email address will not be published. Required fields are marked *