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Inflation
by David Ranson
Inflation is the loss in purchasing power of a currency unit such as the
dollar, usually expressed as a general rise in the prices of goods and
services. A classic example is the Great Inflation of the Roman Empire.
Successive emperors replaced a steadily increasing fraction of the silver
in their ancient currency, the denarius, with base metals like bronze or
copper. As a result prices rose inexorably despite repeated attempts to
restrain them through legislation. Diocletian, rather than taking
responsibility for the debasement, attributed the rapid inflation of his
day to the avarice of his subjects. His famous edict of a.d. 301
threatened with death any vendor who charged prices exceeding official
limits. But inflation ran along unhindered for another century until an
alternative currency, an undepreciated gold coin known to Shakespeare
as the bezant, became the customary unit of account, spreading
throughout Europe and lasting well into the Middle Ages.
In modern times inflation continues to be blamed on private greed, and
governments still seek to restrain it by decree, sometimes even
devaluing their currencies as they do so. The United States has
experienced much inflation during the twentieth century, especially
since official efforts to maintain the gold price at thirty-five dollars an
ounce ceased during the presidencies of Lyndon Johnson (in the world
market) and Richard Nixon (through the "gold window" open only to
foreign central banks). An annual inflation rate of 4 to 5 percent, once
thought to be calamitous, has become routine.
We have many measures of inflation, but none provides a truly reliable
gauge of inflation at any specific time. The most widely watched
measure is the consumer price index (CPI), published monthly by the
Bureau of Labor Statistics. Subindexes are available for different cities
and for many different classes of goods and services.
One problem with the CPI is that the weight attached to each class of
goods and services is held constant for years at a time. Therefore, when
consumers lower their cost of living by buying more items whose
relative price has fallen and fewer items whose relative price has risen,
the CPI will not show a decline in the cost of living. Moreover, the
difficult problem of allowing for changing quality has never been solved.
Nor can the government inspectors who collect the data from retailers
track down all the sales and discounts of which consumers are so keenly
aware. As a result of these and other factors, the consumer price index
reflects inflation trends only with a long delay and portrays an artificially
smooth path for the inflation rate.
Other popular indicators of inflation include producer prices (formerly
known as wholesale prices) and unit-value indexes for imports and
exports. As we move back through the distribution chain from the
consumer toward the supplier of raw materials, a more jumpy picture of
inflation is revealed at each step. Commodities, whose prices can be
monitored continuously on centralized exchanges, and which are easy to
measure, are the most volatile indicators of all. An index of commodity
prices, when plotted on a graph, looks much like an index of stock
prices. But its ups and downs are significant; it provides warning one or
even two years ahead of movements in the consumer price index.
In the news media, discussion of inflation often takes a "bottom up"
view. Each month's change in the CPI can be, and is, split up into
dozens of components, such as food, energy, and housing. It is
tempting to see the sectors where prices rose the most as causes of the
observed inflation. Sometimes policymakers speculate that if "price
pressure" in those areas could be relieved, overall inflation could be
reduced.
This way of looking at inflation is mistaken. The prices of some items
always are rising or falling relative to others. This is a natural feature of
the way a market economy adapts to changes in supply or demand.
Rapid price increases within a single sector, though often labeled
"sectoral inflation," are partly the result of an adjustment in relative
prices and partly a manifestation of the overall inflation rate. They may
have no causative significance whatever. When we watch the tide come
in at the beach, we know that it is not caused by the waves, however
forceful they may be. Inflation is not simply the sum total of a collection
of independent price changes, as the arithmetic of the CPI implies. It is
the degree to which all of those prices move in concert.
Another popular game is to sift out the more volatile items in the basket
of goods and services—often energy and food—and focus on the
remainder as a truer "underlying" or "core" rate of inflation. This
exercise, though it succeeds in producing a less volatile index, is
dubious. The least volatile components are not necessarily the most
informative. Some of them appear to be unresponsive to economic
forces because of pitfalls in measurement or stickiness in their speed of
adjustment to market forces. The price of rental housing, for example,
is fixed month-to-month by contract. At the other end of the scale,
some of the most volatile items—such as precious metals—are highly
informative, to the extent that their movements anticipate a broad
range of sectors where price changes have not yet been perceived.
What does inflation cost? There are polar opinions here, and a lively
debate. In and of itself inflation "costs" little or nothing because it
consists of nothing more than a change in the units we use to measure
prices throughout our economy. It is confusing and irritating to keep
requoting prices, but that's something people get used to, as recent
writers like Paul Krugman and Alan Blinder have emphasized. From this
point of view it is possible to see a steady inflation rate as high as 10
percent annually as nearly costless. But dwelling on this problem misses
the point of the debate.
Economists who view inflation as a very serious problem point to what
they call the "inflation tax." By this they mean the reduction in the
purchasing power of the cash balances held by the private sector—like a
wealth tax. This tax is a drag on the economy—an "efficiency loss"—
because it induces people and businesses to economize on cash
balances, making it more difficult to participate in the money economy.
Economic losses associated with the inflation tax and other distortions
are known as the "welfare cost of inflation." At one extreme of the
debate, Harvard economist Martin Feldstein has claimed that the
present value of the losses that result from unending inflation may be
infinite! His argument is that each year the cost to the economy grows
in proportion to society's money balances. Because the rate of growth of
money balances exceeds the interest rate he uses to calculate the
present value, the present value is unbounded.
But the force of the inflation-tax argument has been depleted in recent
years by the increasing tendency to hold cash in the form of money
market mutual funds and bank deposits that pay interest. The higher
the expected rate of inflation, the higher the interest rate paid by
mutual funds and banks. People have shifted their cash balances to
these types of accounts only recently because government regulations
used to prohibit the payment of interest on checking accounts.
Quite a different problem results from the collision of inflation with the
U.S. tax system, particularly the federal taxes on personal income,
corporate profits, and capital gains. Progressive rate structures were
intended to shift tax burdens from low- to higher-income groups. But
over the years they have instead imposed on the general incomeearning population high tax rates that had originally been thought
appropriate only for millionaires. A family with a constant real income of
$50,000 (in 1978 dollars), for example, was pushed from the 28 percent
bracket in 1965 to a 46 percent rate in 1978. Its average tax rate rose
from 16 percent to 23 percent. Offsetting reductions in tax rates have
been extremely slow to develop, in spite of across-the-board rate cuts
during the Kennedy-Johnson and Reagan years. Instead, government
spending has tended to absorb revenue unintentionally collected as a
result of escalating tax brackets driven by inflation.
The increase in government spending could be claimed as either a cost
or a benefit to the economy, depending on whether one wants more or
less government spending. But there is a real cost that is not
ambiguous. High tax rates on employment, on business investment, and
on the accumulation of capital deter all these activities in favor of
untaxed uses of the economy's resources and, therefore, impede output
and growth.
The effects are visible in the lurching path that the economy has
followed in the past few decades, coupling highs in inflation with lows in
economic growth. Since 1953, as table 1 shows, there has been a
consistently inverse relationship between inflation and growth in the
U.S. economy. This is true not only for the 1973-74 and 1979-80
periods, when large increases in oil prices were partly responsible for
both high inflation and low growth, but for other years as well. Such
evidence undermines the widely held belief in the "trade-off" between
inflation and unemployment.
TABLE 1
Inflation Versus Jobs
The Historical Record, 1953-90
Average Increase in Consumer
Prices
Average Growth of
Employment
Same
Next Cumulativ
Year
Year
e
The Fifties (1953-62)
4 highest-inflation
years
4 lowest-inflation
years
2.3%
0.8%
0.3%
1.1%
0.5
1.4
2.4
3.8
The Sixties (1962-71)
4 highest-inflation
years
4 lowest-inflation
years
4.9%
1.6%
2.0%
3.7%
1.8
2.2
2.4
4.7
The Seventies (1971-80)
4 highest-inflation
years
4 lowest-inflation
years
11.3%
1.1%
1.0%
2.0%
5.4
3.5
3.4
7.1
The Eighties (1980-89)
4 highest-inflation
years
6.4%
1.6%
0.7%
2.4%
4 lowest-inflation
years
3.1
2.1
2.8
4.9
DATA: Consumer price index, all urban consumers; civilian employment (labor force
survey).
SOURCE: Bureau of Labor Statistics.
Still more difficult than measuring inflation is the problem of identifying
its root causes. In spite of its long and rich history, few subjects in the
field of economics are more confused. Professional economists have still
not reached broad agreement as to the origins of the inflation process.
Two camps dominate the debate. Some see inflation as a malady of the
currency (as was surely the case in the Roman Empire). In the words of
Milton Friedman, "Inflation is always and everywhere a monetary
problem." Others see nonmonetary forces at work, such as monopolies,
union demands for higher wages, oil politics, or the "wage-price spiral."
Some nonmonetary ideas are illogical. The existence of monopoly power
or union power might be argued to raise prices generally relative to
what they otherwise would be. But a continuing price rise year-in yearout requires a continuing increase in the degree of monopoly or union
power in the economy. This is neither plausible over long periods of
time, nor consistent with evidence from recent decades for the United
States.
Nonmonetary theories of inflation traditionally separate "demand-pull"
sources from "cost-push" factors like oil, monopoly power, or wages. A
surge in the demand for goods and services in general ("aggregate
demand") is thought to "pull" prices up across the board, especially
when "aggregate supply" is held back by inertia or capacity limitations.
Skeptics rightly question how demand could constantly outstrip supply.
Surely, demand must originate from purchasing power, purchasing
power from wealth, wealth from income, and income from the ability to
produce (and hence supply) goods and services. This contradiction was
understood early in the nineteenth century by Jean-Baptiste Say and
others.
Other logical objections to the idea of demand-pull inflation center on
the importance of money. How could prices rise without a
commensurate increase in the quantity of money in private hands? If
such a thing happened, the purchasing power of the quantity of money
would have declined involuntarily, and that would not be consistent with
market equilibrium. Economists of the "monetarist" school emphasize
the power and discretion of government to vary the money supply,
causing private markets to bring the economy's price structure into
conformity.
Finally, there is strong, though surprisingly little known evidence against
the demand-pull view that excessively rapid economic growth
("overheating") is an important source of inflation. The evidence in table
1 shows that the reverse is nearer the truth for the United States in
recent decades. Inflation has tended to increase in periods of slow
growth or recession and decrease in periods of expansion. The idea that
growth risks inflation is not on as strong a footing factually as the idea
that inflation hurts growth.
Among those who attribute inflation to monetary causes, at least two
quite different views exist. The monetarist view is that increases in the
quantity of money cause inflation. Critics of this view point out that the
quantity of money is difficult to define, especially when funds can be
transferred electronically and credit cards can substitute for cash
balances. It can also be argued that people have freedom to choose the
quantity of money they want to hold rather than merely accept the
quantity the government wishes to impose upon them.
The other monetary view, held historically by opponents of fiat (i.e.,
government) paper money, and by advocates today of restoring the
gold standard, is that the quantity of money can take care of itself.
What really is needed, according to this view, is a mechanism for
keeping the price of the currency stable, for providing an anchor, so to
speak.
Governments have been slow to accept the recommendations of either
of these camps. That probably is because either a strict monetary rule
or strict adherence to a gold standard or other price rule would place
strict limits on discretionary government management of the economy.
About the Author
David Ranson is president of H. C. Wainwright and Company,
Economics, an investment research firm in Boston. He was formerly an
assistant to the secretary of the Treasury in Washington.
Further Reading
Blinder, Alan. "The Efficiency Costs of Inflation: Myth and Reality." In Blinder. Hard Heads, Soft Hearts. 1987.
Feldstein, Martin. "The Welfare Cost of Permanent Inflation and Optimal Short-Run Economic Policy." Journal
of Political Economy 87 (August 1979): 749-68.
Jones, A. H. M. "The Anarchy." In Jones. The Later Roman Empire. 1964.
Krugman, Paul. "Inflation." In Krugman. The Age of Diminished Expectations. 1990.
Laffer, Arthur, and David Ranson. "Inflation, Taxes and Equity Values." Report prepared for H. C. Wainwright
and Company, Economics. September 20, 1979.
Wanniski, Jude. "Money and Tax Rates." In Wanniski. The Way the World Works. 1978.