Academic Agent versus “Adam Friended” on Price Inflation and MMT

Academic Agent has got into another row on MMT, but this time with someone called “Adam Friended.”

In brief, “Adam Friended” responded to Academic Agent in the following video on the issue of MMT and price inflation:



Academic Agent then produced this response on MMT here:



Academic Agent is correct that Covid welfare payments and furlough schemes were not the fundamental drivers of inflation in some goods. It is also true that the Western world is far from full employment (though wage rises clearly can be a driver of price inflation through cost-based mark-up prices).

Unfortunately, “Adam Friended” did not correctly describe the causes of the price inflation in certain goods at the moment, and worse still he does not himself properly understand MMT or Post Keynesian economics, and fails to understand that the naïve Quantity Theory of Money is rejected in MMT and Post Keynesian economics. So this debate between Academic Agent and “Adam Friended” stems from the failure of the latter to correctly state MMT or Post Keynesian theories.

The fundamental causes of the inflation seen in certain goods recently are as follows:

(1) disruption to supply chains because of Covid and lockdowns has caused supply-side inflation, especially in factor inputs. Some nations have also restricted exports of key goods, and lockdowns, in some cases, badly affected production in places like China. In other cases, some nations hoarded supplies of certain food and medical supply products, which restricted overseas exports and caused some inflation.

(2) the price of oil has been rising sharply since last year, and since energy is a fundamental factor input cost, the rise in costs is passed on via cost-based mark-up prices;

(3) there has been disruption of agricultural production and inflation in certain food products and in some agricultural inputs. For example, lockdowns and closing of borders have disrupted production and processing of agricultural goods.

The evidence for this can be seen in this IMF paper called “The Impact of COVID-19 on Inflation: Potential Drivers and Dynamics”.

So, in other words, the recent inflation in certain goods prices is mainly and fundamentally caused by real factors like supply disruptions, lockdowns, hoarding and shortages, not monetary factors.
Some demand-pull inflation after supply disruptions has happened, but the real factors are more important, and, as we will see below, Austrians like Academic Agent fail to understand the true extent of demand-pull inflation.

However, it is important to put this into perspective via the general price indices.

American and UK inflation is historically low, as we can see here for the US and here for the UK (just click on the “25Y” or “Max” tabs above the graphs to see the long-run historical inflation rates). None of this has caused high or even moderate general price inflation.

Academic Agent’s fundamental claim in his video (see his comments from 35:18 and 36:09) appears to be that expansion of the money supply via central banks is the fundamental driver of the price inflation in some goods today. This is absurd, and the actual evidence, as I stated above, shows real factors were the driver of the inflation because of supply disruptions, lockdowns, hoarding and shortages.

Worse still, Academic Agent in his reply video makes other errors and fails to understand MMT and even his own Austrian theory.

Let’s review these errors below.

The Austrian Theory of Price Inflation
Academic Agent is so ignorant he actually states in his video that the “Austrian theory would say ... inflation is always a monetary phenomenon” (see 11:36–11:42). By “inflation” Academic Agent clearly means “price inflation” and not merely expansion of the money supply.

Academic Agent is blatantly wrong about Austrian theory.

The idea that “inflation is always and everywhere a monetary phenomenon” is a Monetarist theory on the basis of the Quantity Theory of Money.

In reality, the Austrian school does not wholly subscribe to the Quantity Theory of Money, but have their own criticisms of it, because of the issue of Cantillon effects, as well as other criticisms.

Academic Agent is apparently unaware that the Austrian school actually has serious criticisms of the orthodox Quantity Theory of Money.

First let us take the view of Ludwig von Mises:

“ [sc. Mises] … agreed with the classical ‘quantity theory’ that an increase in the supply of dollars or gold ounces will lead to a fall in its value or ‘price’ (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the ‘quantity of money’ does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the ‘price level,’ as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well” (Rothbard 2009: 15).

In other words, Mises denied that a given increase in the money supply (say, 5%) would lead to a direct, proportional and mechanistic rise of 5% in the general level of prices.

Strictly speaking, then, Mises denied the orthodox Quantity Theory of Money.

The naïve monetarists believe that there is a “monocausal” explanation of inflation: money supply growth which will cause direct, proportional increases in the price level, at the very least in the long run, even if Monetarists will accept short-run non-neutrality of money.

Friedrich von Hayek believed that a simple form of the quantity theory was a “helpful guide,” but was nevertheless a critic of the theory, both in the version of it propounded by Irving Fischer and the restatement of it by Milton Friedman (Arena 2002).

In particular, “Hayek criticized Friedman for concentrating too much on statistical relationships (between the quantity of money and the price level), claiming that matters are not quite that simple” (Garrison 2007: 3). Modern Austrians continue to be critical of Quantity Theory of Money, like Jesús Huerta de Soto, who has the following to say:

“[sc. The equation MV=PT of the quantity theory] contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure” (Huerta de Soto 2009).

The Austrians think that quantity theory is inadequate because it ignores their theory that increases in the money supply distort relative price and the productive structure of an economy, which is, in essence, the Austrian Business Cycle Theory (ABCT).

If we dig deeper into Austrian view of inflation, we can find some surprisingly sensible analysis.

Frank Shostak has this view:

“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.”
Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.

The statement that prices “are determined by real and monetary factors” is empirically correct, but requires that the Monetarist view – defended by Academic Agent – that “inflation is always and everywhere a monetary phenomenon” is false.

So Academic Agent does not even understand the Austrian theory he comically defends!

Of course, even the Austrian view of Frank Shostak is seriously flawed in that it does not understand endogenous money or the widespread existence of cost-based mark-up prices.

In reality, most prices are cost-based mark-up prices which are relatively inflexible with respect to demand, either as compared with the 19th century or in the grossly unrealistic models of the worst sort of Neoclassical economics and Austrian theory. This means that increases in demand or purchases of goods via new money (most of which is simply created by private banks anyway via new loans) simply do not bid up prices rapidly or significantly in the way Austrians imagine, precisely because of relative price rigidity. This means that the extent of demand-side price inflation – though it does exist – is grossly exaggerated by Austrians.

To be clear: demand-pull inflation certainly exists, but it is often not the main cause of price inflation in the modern world, and its extent is much more limited.

Changes in the general price level are a highly complex result of many factors, and not a simple function of money supply.

Businesses will raise their prices for all sorts of reasons independently of a money supply expansion.

Often general price inflation is a cost-push phenomenon, in which

(1) workers or unions demand higher wages and businesses agree to these increases and/or

(2) prices of other factor inputs rise, and then businesses raise prices to reflect higher unit costs.

While a long-run, sustained price inflation does need a growing money supply to sustain it, the money supply is often not the causal factor in such price inflations, but the intermediary factor. Often, it is business and corporate use of cost-based mark-up prices and their pricing decisions, on the basis of the need for more profit or higher unit costs, which drive price inflations.

Monetarists make the mistake of thinking that the intermediary medium (money supply) is the only and fundamental driver of price inflation, when real factors underlie many movements in prices.

The MMT Job Guarantee
Academic Agent asks how a Job Guarantee will not cause high inflation under MMT.

The answer is that the MMT job guarantee is designed to pay a minimum wage, so that workers can be bid away from it to the private sector with higher private sector wages.

In cases where private sector employment already pays above minimum wage (which is very many sectors), there is no significant inflation issue.

It is true that there might be some wage inflation where private sector employment already pays a minimum wage and private businesses have trouble finding workers, but this process happens already, and is not going to cause the type of huge or significant inflation Austrian-school supporters like Academic Agent pretend will happen.

Quite simply, low-level price inflation is better for a modern economy than price deflation, since price deflation causes devastating macroeconomic effects, like profit deflation in the face of money wage rigidity, debt deflation, deferral of purchases of goods, and pessimistic business expectations.

The Austrian complaint that the MMT job guarantee might cause some low-level inflation is utterly spurious, since low-level price inflation is far better than price deflation.

BIBLIOGRAPHY
Arena, R. 2002. “Monetary Policy and Business Cycles: Hayek as an Opponent to the Quantity Theory Tradition,” in J. Birner, P. Garrouste, T. Aimar (eds.), F. A. Hayek as a Political Economist: Economic Analysis and Values. Routledge, London.

Garrison, R. 2007. “Hayek and Friedman: Head to Head”
http://www.auburn.edu/~garriro/hayek%20and%20friedman.pdf

Huerta de Soto, J. 2009. “A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money,” Economicthought.net
http://www.economicthought.net/2009/07/a-critique-of-the-mechanistic-monetarist-version-of-the-quantity-theory-of-money/

Rothbard, M. N. 2009. The Essential von Mises. von Mises Institute, Auburn, Alabama.

Shostak, F. 2002. “Defining Inflation,” Mises Daily, March 6
http://mises.org/daily/908

Hayek the Evil Inflationist!

… or that is what I would call this post if I were a Misesian or Rothbardian Austrian economist.

I refer to the passage below from a talk that Hayek gave on April 9, 1975 to the American Enterprise Institute in Washington DC, in which he had been asked to speak on 1970s inflation.

Early in this talk Hayek said that he rejected the Keynesian view that employment is “a direct and simple function of what is called aggregate demand” (Hayek 1975: 4), even though he proceeded to concede two important instances where aggregate demand was the “dominating factor in determining the level of employment”:

“Let me say, first, that there are two circumstances in which changes in aggregate demand are indeed the dominating factor in determining the level of unemployment; and these two circumstances have governed the development of the theory.

The first one was an accidental historic situation—but an historic situation that determined the climate of opinion in the country which then dominated economic theory. In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.

This particular situation, however, while it largely explains the growth of Keynes’s own views, would not be sufficient to explain their wide acceptance.

The second situation in which it is true that an increase of employment requires an increase in aggregate demand is found in the later stages of a depression when, in consequence of the appearance of extensive unemployment, the economy frequently is subjected to a cumulative process of contraction. The original substantial unemployment lends to a shrinkage of demand that causes more unemployment, and so on; it releases a deflation due to the ‘inherent instability of credit’ (to use the terminology of a once very influential but now undeservedly almost forgotten economist who died a few days ago, R. G. Hawtrey).

Once you have the kind of situation in which there already exists extensive unemployment, there is thus a tendency to induce a cumulative process of secondary deflation, which may go on for a very long time. I am the last to deny — or rather, I am today the last to deny—that in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate.

I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression. At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was compatible with a functioning economy. Perhaps I should even then have understood that this possibility no longer existed. I think it disappeared in 1931 when the British government abandoned its attempt to bring wages down by deflation, just when it seemed about to succeed. After that attempt had been abandoned, there was no hope that it would ever again be possible to break the rigidity of wages in that way.

I still believe that we shall not get a functioning economy until wages again become flexible, but I think that we shall have to find different techniques for that purpose. I would no longer maintain, as I did in the early ’30s, that for this reason, and for this reason only, a short period of deflation might be desirable. Today I believe that deflation has no recognisable function whatever, and that there is no justification for supporting or permitting a process of deflation.” (Hayek 1975: 4–5).

This is Hayek’s mea culpa and a repudiation of his 1930s liquidationism.

But what policy does Hayek recommend to avoid deflation? He does not here specify how, but elsewhere makes it clear that he supported monetary intervention (like Milton Friedman) and (probably) a guarded and conservative use of fiscal policy involving public works expenditure. In one word: inflation.

Most interesting is Hayek’s implicit admission that inflation was the right course for the British economy in the 1920s after the disastrous return to the gold exchange standard at too high a parity:

“In 1925, Great Britain had made a laudable attempt to return to gold but mistakenly to do so at the former parity. This policy created a situation where real wages were generally too high because they had been artificially raised by the revaluation of the pound. In consequence, British industry, largely dependent on exports, had become unable to compete in the world market. In this situation, the restoration of employment required a reduction of real wages which could be achieved by a general rise of prices.”

So Hayek, after all his attacks on Keynes in the 1930s, essentially admitted Keynes was right, at least on these points at any rate.

BIBLIOGRAPHY
Hayek, Friedrich A. von. 1975. A Discussion with Friedrich A Von Hayek. American Enterprise Institute, Washington.

Austrians and the Definition of “Inflation”

Certain Austrians are running to defend their idiosyncratic definition of “inflation” as an increase in the money supply, instead of (as people normally use it) a general increase in prices.

The fact is that the word “inflation” has always been used to describe a general increase in prices, as well as an expansion of the money supply. This can be clearly seen to anyone who does a few minutes of searching on Google Books for the word “inflation” in the 19th century.

Even in the 19th century, people frequently spoke of an “inflation of the currency” or “inflation in (the) currency” and “inflation of prices” or “inflation in prices.” These expressions appear in the English language from about 1834. When referring to monetary expansions, people in the 1800s also often used the phrases “expansion of credit,” “over-issue of credit,” or “over-issue of (the) currency,” and so on.

Just looking at this graph of usage (better viewed in a separate window) from a search on Google Ngram Viewer, the expression “inflation of prices” is very common in the 19th century, and in some years more common than the expression “inflation of the currency.” As already noted, both appear around 1834.

Furthermore, as we can see in this next graph, the expression “inflated prices” appeared in the late 1790s at the time of the French Revolutionary wars, and so the use of the cognate word “inflated” in an economic sense referring to prices preceded the phrases above.

Even single uses of the word “inflation” in sources from the 1800s can have either meaning, depending on the context.

Examples of “inflation” in the sense of “price inflation” are easy to find:

“The question recurs, what were the causes of the unusual mania of speculation — the excessive and long continued inflation of prices, and the confidence that this inflation, after it was known to be excessive, would continue, and the expectation that it would still further increase?”
Nathan Hale (ed.), Chronicle of Events, Discoveries, and Improvements, for the Popular Diffusion of Useful Knowledge Nathan Hale. S. N. Dickinson, Boston. 1840. p. 11.

“Now, however, without any inflation, and in some important articles under a contraction of prices, the excess of exports is not only more than was ever known before, but quite threefold greater, ...”
William Hanby Crump, The World in a Pocket Book: Or, Universal Popular Statistics. J. Dobson, Philadelphia, 1841. pp. 118–119.

“The expression ‘war prices,’ so commonly used in the past, implied the inflation in values of all kinds of property rated in such representative money, the volume of money largely controlling the degree of inflation in values, but not absolutely, ... ”
John Smith, Hard Times: A Few Suggestions to the Workers and a Broad Hint to the Rich. 1885. p. 45.

“But such a currency so handled cannot cause inflation. Prices remain, as before, at the gold level.”
Littell’s Living Age, Volume 186, T.H. Carter & Company, 1890. p. 648.

“Taking inflation to mean a rise in prices, unaccompanied by a corresponding rise in values, inflation can never be brought about by a mere increase in the volume of gold employed in commerce.”
Blackwood’s Edinburgh Magazine, Volume 149, 1891. p. 401.

“This increase in prices we call inflation, and I do not understand how such an inflation can be repudiated, as has been done to day, while the entire remedy proposed, imaginary or real, evidently is intended to produce a notable increase of prices called forth by inflation.”
Berlin Silver Commission, 1894: Proposals Submitted and Debate on the Proposals. Report of the Proceedings, to which is Appended the Report of the Proceedings of the International Bimetallic Conference at London May 2 and 3, 1894, Volume 2, U.S. Government Printing Office, 1895. p. 775.

US Inflation Rates (1946–1987), Keynesianism and Stagflation

It is sometimes claimed that the Keynesian golden age of capitalism (1946 to 1973) had an accelerating inflation rate. The story goes: all Keynesianism did was cause a never-ending, upward trend in inflation rates.

The myth was peddled by (of all people!) the British Labour politician James Callaghan (UK Prime Minister from 1976 to 1979) when in 1976 he declared that Keynesianism “only worked on each occasion ... by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment as the next step,” before he introduced at least a rhetorical commitment to a pre-Thatcherite form of monetarism in the UK.

But it is nonsense, certainly in the case of the US, as we can see in the graph below.




There were two outliers: the post-WWII inflation and the Korean War inflation. But, apart from these, the inflationary spike that did break out after 1968 was unusual and a deviation from the basic price stability of the golden age. That price stability was most notable for the late 1950s and most of the 1960s. In fact, actual deflation briefly occurred twice in the post-WWII era.

As Nicholas Kaldor long ago noted, during the golden age “for a long time the rate of inflation (as measured by consumer prices) remained moderate, and until the closing years of the 1960s it showed no clear tendency to acceleration” (Kaldor 1976: 214).

The reason for the inflationary crisis of the 1970s was four-fold:

(1) From 1968–1971 there were the beginnings of inflationary pressures, in both wages and prices in many industrialised nations. The fundamental cause was that around 1968–1969 in Japan, France, Belgium and the Netherlands and from 1969–1970 in Germany, Italy, Switzerland and the UK wage rises had occurred, which Kaldor attributes to strong action by unions (Kaldor 1976: 224). There is a perpetual struggle between capitalists and labour over distribution of income, and it just happened that around 1968 to 1970 labour won out in many countries causing a bout of cost-push inflation (via wage increases). But this would not have become a serious problem had it not been for factors (2), (3), and (4).

(2) the dismantling of commodity buffer stock policies that had previously ensured price stability. The prelude to stagflation was marked by a significant explosion in commodity prices that occurred in the second half of 1972. Part of the problem was the failure of the harvest in the old Soviet Union in 1972–1973 and the unexpectedly large purchases on world markets by the Soviet state. This could have been averted had the United States not dismantled its commodity buffer stock policies in the 1960s.

(3) The end of Bretton Woods (the post-WWII international monetary system) was momentous: inflationary expectations and instability on financial and commodity markets resulted, as well as a rise in commodity speculation as a hedge against inflation. This contributed to the cost-push inflation that was being felt in many countries after 1971.

(4) The final factor that caused the severe inflation of the 1970s was the first oil shock from October 1973, when various Middle Eastern producers of oil instituted an embargo that lasted until March 1974 (Kaldor 1976: 226). In most countries, the double digit inflation of the 1970s was caused by the oil shocks (both the first and second).

The unfortunate concatenation of these historically unprecedented shocks – that is, factors (1), (2), (3), and (4) – in toto was the cause of 1970s stagflation.

Kaldor stresses the importance of factor (2). During most of the golden age of capitalism (1945–1973), primary commodity buffer stocks had created stable prices. But this policy was changed in the 1960s when the US modified its buffer stock policies:

“… the duration and stability of the post-war economic boom owed a great deal to the policies of the United States and other governments in absorbing and carrying stocks of grain and other basic commodities both for price stabilisation and for strategic purposes. Many people are also convinced that if the United States had shown greater readiness to carry stocks of grain (instead of trying by all means throughout the 1960s to eliminate its huge surpluses by giving away wheat under PL 480 provisions and by reducing output through acreage restriction) the sharp rise of food prices following upon the large grain purchases by the U.S.S.R. [in 1972–1973], which unhinged the stability of the world price level far more than anything else, could have been avoided.” (Kaldor 1976: 228).

That was a major factor causing stagflation, along with wage–price spirals. The first oil shock was a final factor that exacerbated everything.


BIBLIOGRAPHY

Kaldor, N. 1976. “Inflation and Recession in the World Economy,” Economic Journal 86 (December): 703–714.

Two Austrian Definitions of Inflation

A post here on the Mises.org blog raises some interesting questions about the Austrian definition of inflation:

Per Bylund, “Inflation and Deflation: Austrian Definitions,” November 18, 2011.

In essence, the author cites this definition of inflation by Mises in his treatise The Theory of Money and Credit (1953):

“In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur. Again, Deflation (or Restriction, or Contraction) signifies: a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange-value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange-value of money did not alter could hardly ever exist for very long. The theoretical value of our definition is not in the least reduced by the fact that we are not able to measure the fluctuations in the objective exchange-value of money, or even by the fact that we are not able to discern them at all except when they are large.” (Mises 2009 [1953]: 240).

The significance of this passage is discussed by Horwitz (2000: 78), who argues that it appears to allow the idea that a fractional reserve banking system could create credit (fiduciary media) in response to demand for it, without, in Mises’s view, causing inflation.

In contrast to this, we have the definition of Murray Rothbard in Man, Economy, and State: A Treatise on Economic Principles (1962):

“The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called inflation. A contraction in the money supply outstanding over any period (aside from a possible net decrease in specie) may be called deflation. Clearly, inflation is the primary event and the primary purpose of monetary intervention. There can be no deflation without an inflation having occurred in some previous period of time. A priori, almost all intervention will be inflationary. For not only must all monetary intervention begin with inflation; the great gain to be derived from inflation comes from the issuer’s putting new money into circulation.” (Rothbard 2004 [1962]: 990).

This definition obviously contradicts that of Mises, and what we have here is another quite clear division within the Austrian school between those who

(1) hold to the “monetary equilibrium” view of inflation as increases of money greater than the demand to hold it (such as Steve Horwitz, and a view which is most probably held by all Free Bankers), and

(2) the Rothbardians and other anti-fractional reserve bankers who regard any increase in the money supply not backed by commodity money as inflation.

BIBLIOGRAPHY

Horwitz, S. 2000. Microfoundations and Macroeconomics: An Austrian Perspective, Routledge, London and New York.

Horwitz, S. “Mises Defining Inflation the Monetary Equilibrium Way (in 1951),” Coordination Problem, September 3, 2009.

Mises, L. von, 2009 [1953]. The Theory of Money and Credit (trans. J. E. Batson), Mises Institute, Auburn, Ala.

Rothbard, M. N. 2004 [1962]. Man, Economy, and State: A Treatise on Economic Principles, Ludwig von Mises Institute, Auburn, Ala.

Inflation and the Fall of the Roman Empire

The myth that the Roman empire fell because of economic problems caused by inflation dies hard, and you can find it used by Austrians and free market libertarians:

Peden, Joseph R. 2009. “Inflation and the Fall of the Roman Empire,” Mises Daily, September 7.

Bartlett, B. 1994. “How Excessive Government Killed Ancient Rome,” Cato Journal 14.2 (Fall): 287–303.

There are a number of points to make in response to these attempts to blame government intervention and inflation for Rome’s fall:

(1) What do we mean by the “fall of the Roman empire”? In fact, the Roman empire split into two by the fourth century AD, with one emperor in the West and one in the East. The expression the “fall of the Roman empire” actually refers to the collapse of the western Roman empire: the Eastern Roman empire (or the “Byzantine” empire) continued, with its fortunes waxing and waning, until 1453 AD. The “fall of the Roman empire” describes the loss of territory the Western empire experienced from about 400 AD onwards.

(2) While the Roman empire was hit by severe monetary inflation from the late third century to the early fourth century AD, the economic crisis largely abated by the mid-fourth century (Whittaker 1980). The Eastern Roman empire had been hit by the same inflationary crisis, but it never fell. Moreover, while the inflation had bad social effects, the full effects are not clear to us. The majority of the population of the Roman empire were peasants, but they were largely self-sufficient:

“modern scholars seem agreed that inflation only hurt a small section of the population; maybe ‘craftmen’, or possibly only ‘the small creditor class and urban professional (a teacher for instance)’, but neither the peasant nor the magnate suffered. Whatever stratum of society suffered, it did not do so across the whole empire. The Roman empire was never a unified economy; each province followed its own trajectory” (Sidebottom 1998: 2800–2801).

Since the vast majority of the population was rural and engaged in farming (the most important productive activity in the empire), the inflationary crisis of the late empire probably had no great effect on them.

(3) The Western empire persisted for nearly 50 years after the end of the inflation before it began to gradually lose its territory, and as late as 357 the Roman Caesar Julian the Apostate (emperor from 355 to 363) was able to inflict a crushing defeat on the Germans (the Alamanni and Franks) at the Battle of Argentoratum, when they were attempting to invade the empire. The devastating defeat the Romans later experienced at the battle of Adrianople (378 AD) when the eastern Roman Emperor Valens fought a Gothic army was clearly caused by strategic and tactical errors, and not because of the empire’s fiscal problems or inability to field an army.

(4) The West lost most of its empire owing to barbarian invasions from 400–450, and there is an obvious explanation for this: military and strategic errors by generals and emperors. The Western empire ended in 476 AD because of a simple internal rebellion when the last Roman emperor (Romulus Augustulus) was deposed by Odoacer, the barbarian leader of mercenaries in Italy who had been proclaimed king of Italy.

(5) The economic problems that the Roman empire faced after the third century AD were of course real, but not the result of the simple morality tale about inflation spun by apologists for free market economics:

“According to the monetarist view, what buried Rome was inflation stemming from government spending and adulteration of the coinage, coupled with what Mikhail Rostovtzoff deemed to be over-taxation of the middle class. But what actually led to fiscal and monetary breakdown in the every major society from Babylonia through the Roman and Byzantine empires to more modern times was the ability of large property owners to break free of taxes. The Roman treasury was bankrupted by wealthy landowners using their control of the senate to shift the fiscal burden onto classes below them. Lacking the means to pay, these classes were driven below the break-even point. As debt deflation drained the economy of money, barter arrangements ensued. Trade collapsed and the economy shrunk into local self-sufficient manor units” (Hudson 2003: 53).

In other words, it was the super rich and propertied classes who evaded taxation and forced a highly regressive tax system on the middle classes and poor. The economic problems can be related to the structure and unfair burden of taxation, not taxation per se.

(6) The effects of deflation and debt deflation are ignored by Austrian economists and others. The Roman Republic (which existed before the empire) in fact faced excessive debt and deflationary periods in the first century BC, especially in the 90s and 80s BC, which caused serious social and economic problems (for deflation in the Republic, see Barlow 1980; Nicolet 1971; cf. Verboven 1997). Thus it was not just inflation that had undesirable effects, but also deflation (see my post “Debt Deflationary Crisis in the Late Roman Republic,” June 16, 2011).

BIBLIOGRAPHY

Barlow, C. T. 1980. “The Roman Government and the Roman Economy, 92–80 B.C.,” American Journal of Philology 101.2: 202–219.

Hudson, M. 2003. “The Creditary/Monetarist Debate in Historical Perspective,” in S. A. Bell and E. J. Nell (eds), The State, the Market, and the Euro: Chartalism versus Metallism in the Theory of Money, Edward Elgar, Cheltenham. 39–76.

Nicolet, C. 1971. “Les variations des prix et la ‘théorie quantitative de la monnaie’ à Rome, de Cicéron à Pline l’Ancien,” Annales, Économies, Sociétés, Civilisations 26: 1208-1227.

Sidebottom, H. 1998. “Herodian’s Historical Methods and Understanding of History,” ANRW II.34.4: 2775–2836.

Verboven, K. 1997. “Caritas Nummorum. Deflation in the Late Roman Republic?,” Munstersche Beitrage zur Antiken Handelsgeschichte 16.2: 40–78.

Whittaker, C. R. 1980. “Inflation and the Economy in the Fourth Century A.D.,” in C. E. King (ed.), Imperial Revenue, Expenditure, and Monetary Policy in the Fourth Century A.D., B.A.R., Oxford, 1–22.


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The Austrian Theory of Inflation: Myths and Reality

Many libertarians, advocates of free market economics or supporters of Austrian economics complain repeatedly about fiat money and increases in the money supply.

Typically, they complain that any increase in the money supply must always lead to a rise in the price level or the inflation rate.

Here is a video of Ron Paul complaining about the Federal Reserve’s creation of money because it will lead to inflation.

It is a view that you find frequently in pro-free market, libertarian, and populist Austrian blogs or commentary.

A very general statement of the Austrian theory of inflation can be found on Wikipedia:

“The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time. This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply. In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.” http://en.wikipedia.org/wiki/Inflation#Austrian_theory.

So firstly the word “inflation” is defined specifically as an increase in the money supply, and contrary to the popular definition of “an average increase in the price level.” In the Austrian theory, “inflation” is not a general increase in prices, but an increase in the money supply.

The purpose of this post is to show that many people today who are sympathetic to Austrian economics or who are self-proclaimed followers of the Austrian school actually do not understand the Austrian theory of inflation and the price level.

Many people cannot distinguish Milton Friedman’s monetarist theory of the price level (based on the quantity theory of money) from the Austrian view, which is actually quite different from Friedman’s and, moreover, has changed over time.

First, it is necessary to say a word about the quantity theory of money. Contrary to what many believe, Austrians have always had an ambivalent and even critical attitude to the quantity theory of money. The quantity theory of money is the basis of Milton Friedman’s monetarism, a macroeconomic theory that became popular in the late 1970s and early 1980s. The quantity theory is also used frequently by pro-free market writers to decry expansion of the money supply under a fiat monetary system.

However, many Austrians actually have a rather sceptical view of the quantity theory.

Ludwig von Mises, for instance,

“agreed with the classical ‘quantity theory’ that an increase in the supply of dollars or gold ounces will lead to a fall in its value or ‘price’ (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the ‘quantity of money’ does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the ‘price level,’ as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well” (Rothbard 2009: 15).

In other words, Mises denied that a given increase in the money supply (say, 5%) would lead to a direct, proportional and mechanistic rise of 5% in the general level of prices.

The naïve monetarists believe that there is a “monocausal” explanation of inflation: money supply growth which will cause direct, proportional increases in the price level. This is ridiculous.

Friedrich August von Hayek believed that a simple form of the quantity theory was a “helpful guide,” but was nevertheless a critic of the theory, both in the version of it propounded by Irving Fischer and the restatement of it by Milton Friedman (Arena 2002). In particular, “Hayek criticized Friedman for concentrating too much on statistical relationships (between the quantity of money and the price level), claiming that matters are not quite that simple” (Garrison 2007: 3). Modern Austrians are divided on the issue of the quantity theory of Friedman. Some continue to be critical, like Jesús Huerta de Soto:

“[sc. The equation MV=PT of the quantity theory] contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure” (Huerta de Soto 2009).

The Austrians think that quantity theory is inadequate because it ignores their theory that increases in the money supply distort the productive structure of an economy – a cause, they believe, of recessions.

These Austrian views of the quantity theory are frequently ignored or simply unknown to many who hold a crude, vague or confused Austrian view of economics.

Austrians, in essence, have two objections to inflation. The visible effect (if output does not rise) is rising prices. This could be rising prices in goods and services (not necessarily uniformly), but also in the prices of financial and real assets. Austrians quite reasonably include asset price inflation in the overall price level (note that the prices of stocks, bonds, other financial assets, real estate, and commercial property are not normally included in consumer prices indices). But their further complaint is that there is also an invisible effect: the increasing money supply stops the money stock from remaining stable and hence it prevents deflation, which would increase the purchasing power of money. A rising money stock, therefore, does not allow money’s purchasing power to increase through price deflation.

With respect to asset price inflation, the Austrian view ignores the fact that effective financial regulation can prevent bubbles, especially in real assets like housing and real estate. The US, for instance, had stable housing prices from about 1950 until the mid-1970s, and the same was true in many other countries, because of regulation.

The Austrian claim that money supply increases cause the invisible effect of preventing deflation ignores the fact that, although price deflation increases money’s purchasing power, deflation can have devastating effects on economic activity. Debts, for instance, are fixed in nominal terms and, when deflation causes wage and price falls, debtors face a greater burden in repaying debt. The Austrians argue that the gold standard should be restored, but this would leave the level of the money supply subject to external factors like discoveries of gold and the current account balance. In fact, the gold standard was no guarantee of zero inflation: the UK was on the gold standard and had persistent inflation between 1897 and 1912, partly because of the influx of gold from new discoveries.

Furthermore, when we examine articles on the Austrian theory of inflation at the Ludwig von Mises Institute by more academic Austrian scholars, we even find a more balanced argument:

“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.”

Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.

Shostak also believes that increasing the money supply leads to a misallocation of resources. This is indeed possible, especially in an unregulated financial system, but it is by no means necessary or inevitable. Credit has to be given to the Austrians for their business cycle theory, because at the time when they first produced it (in the 1920s and 1930s) it was an improvement over the neoclassical view that business cycles caused by a failure of aggregate demand could not occur in capitalism because of Say’s law, and also because the Austrians (like the post Keynesians) correctly saw that money is not “neutral”. However, Austrian business cycle theory still has major flaws and it cannot be accepted, though that is a topic for another essay.

The important point, however, is that Shostak is careful to qualify his statement quoted above. He says that increasing the money supply will always cause an increase in the level of prices, but then concedes that prices are also “determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.”

This is a very important qualification. He is right that the inflation rate (the rate of increase in a price index like the CPI) and changes in the level of prices also depend very much on real factors, as well as monetary ones. For example, the following factors could tend to decrease the level of prices:

1. the falling prices of specific goods through increasing productivity or output;
2. an appreciating exchange rate;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money;
6. higher unemployment (= less demand for goods and services), and
7. a fall in extension of bank credit.

In reality, all or some of these factors listed above could operate to cause either a zero inflation rate (which Japan actually had in 1996 and 2004) or a fall in average prices (deflation), even when the money supply is still actually increasing.

We can take a real world example. In the late 19th century, the UK experienced sustained price deflation from 1873–1896. However, the actual broad money stock was rising in these years: between 1873–1896 the money stock grew by about 1.3% a year, or over the entire period by about 33%. Yet between 1873–1896 wholesale prices fell by 39%. What happened was that in this period the money supply was rising, but not as fast as demand for money, and also steep falls in the prices of agricultural commodities contributed to the fall in overall prices (Capie and Wood 1997: 287–289).

Now Shostak’s slightly more balanced Austrian view that an increasing money supply does not always necessarily lead to a rise in the price level is hardly ever considered by popular proponents of Austrian school economics.

Instead, we hear endless rants about how increasing the money supply always and automatically devalues or reduces money’s purchasing power.

This simply ignores the fact that the mechanism that reduces the purchasing power of money is an average increase in the price level.

Once it is conceded that (1) the relationship between a rising money stock and rising price level is not automatic, necessary or inevitable and (2) the Austrian business cycle theory is wrong, most of the popular and crude objections to an increasing money supply collapse.

But there is more to be said. If we go right back to the work of Ludwig von Mises in The Theory of Money and Credit (1912), we actually find another definition of inflation:

“In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur. Again, Deflation (or Restriction, or Contraction) signifies: a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange-value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange-value of money did not alter could hardly ever exist for very long. The theoretical value of our definition is not in the least reduced by the fact that we are not able to measure the fluctuations in the objective exchange-value of money, or even by the fact that we are not able to discern them at all except when they are large” (Mises 1953).

This definition of inflation is hardly ever used by popular followers of Austrian school economics.

The fundamental fact is that Mises did not define an increase in the money supply accompanied by a corresponding demand for money as inflation.

As interpreted by a modern Austrian scholar:

“Mises …. suggests inflation [is] … ‘an increase in the quantity of money above the market demand of money.’ Note that, under Mises’ suggested definition, not every increase in the quantity of money is inflation, only increases that exceed market demand …. [Mises] saves the term inflation for cases where the quantity of money is increasing above the market demand for money” (Cachanosky 2009: 5).

That means that the money supply can continuously rise in proportion to the demand for money, and that this is presumably not objectionable in Mises’ theory.

This is a far cry from some modern advocates of a crude Austrian or quantity theory of money, who complain that any increase in the money supply is bad and will cause a rise in prices.

In addition, if you reject Austrian business cycle theory, this passage quite obviously raises the question of why a rise in fiat money in response to the demand for it in an economy with effective financial regulation that channels credit to productive investments (rather than asset bubbles or speculation) would be a bad thing.


BIBLIOGRAPHY

Arena, R., 2002, “Monetary Policy and Business Cycles: Hayek as an Opponent to the Quantity Theory Tradition,” in J. Birner, P. Garrouste, T. Aimar (eds), F. A. Hayek as a Political Economist: Economic Analysis and Values, Routledge, London.

Cachanosky, N., 2009, “The Definition of Inflation According to Mises: Implications for the Debate on Free Banking,” Libertarian Papers Vol. 1, Art. No. 43.

Capie F. H. and G. H. Wood, 1997, “Great Depression of 1873-1896,” in D. Glasner et al. (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York, 287–289.

Garrison, R., 2007, “Hayek and Friedman: Head to Head”
http://www.auburn.edu/~garriro/hayek%20and%20friedman.pdf.

Huerta de Soto, J., 2009, “A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money,” Economicthought.net
http://www.economicthought.net/2009/07/a-critique-of-the-mechanistic-monetarist-version-of-the-quantity-theory-of-money/.

Mises, L. von, 1953, The Theory of Money and Credit (trans. H.E. Batson), J. Cape, London.

Quiggin, J., 2009, “Austrian Business Cycle Theory,” May 3rd
http://johnquiggin.com/index.php/archives/2009/05/03/austrian-business-cycle-theory/.

Rothbard, M. N., 2009, The Essential von Mises, von Mises Institute, Auburn, Alabama.

Shostak, F., 2002, “Defining Inflation,” Mises Daily, March 6
http://mises.org/daily/908.