Money supply, not psychology

Money supply, not psychology
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First Published: Tue, Sep 09 2008. 12 43 AM IST

Illustration: Malay Karmakar / Mint
Illustration: Malay Karmakar / Mint
Updated: Tue, Sep 09 2008. 12 43 AM IST
A triumph of education during the 20th century was that economists convincingly argued that inflation was caused by excessive monetary creation, usually at the behest of politicians.
Since then, hyperinflation that once plagued much of Latin America became a rarity. “Garden variety” inflation seemed to be tamed in industrialized countries. This changed quite recently, with Zimbabwe concocting inflation that would shame the efforts of the inter-war Weimar Republic to destroy the value of the Reichbank’s mark.
Illustration: Malay Karmakar / Mint
Now, it is clear that rumours of the death of ordinary inflation elsewhere were largely exaggerated. Recent, unfortunate, lapses in keeping inflation at bay are yet again the result of rapacious rulers and incompetent central bankers. It seems that lessons that were so long in learning have been lost so quickly.
In earlier days, politicians were able to feign innocence and shift the blame for inflation to others. But central bankers are playing similar games—by trying to shift blame when price indexes began rising. And they redefined price indexes to understate the effect of their policies.
Another ploy: Central bankers claim that expectations of consumers or producers are a driving force in an economy, a view held by many mainstream economists. As such, “positive” thinking or “good” news can prevent bad expectations from developing that might cause a fall in economic activity. And if individuals are driven by psychological processes and susceptible to wild swings, insights into these processes can lead to better public policy.
For example, inflationary expectations are currently receiving extensive media coverage. Central bankers and policymakers are making noises on how important it is to dampen expectations of future price rises.
It is as though prudent policymakers can make timely interventions to control mass psychology to keep an economy on a stable path. Presumably, convincing individuals that everything is fine can change economic fundamentals and reverse conditions that presage a decline.
Expectations are neither necessary nor sufficient for increasing price levels. Economic theory and historical evidence indicate that an inflated money supply is the primary and fundamental cause of rising prices.
If the central bank does not inflate the money supply, there can be no general acceleration in prices regardless of so-called inflationary expectations. Even if a sudden and sharp increase in the price of energy or food induced people to expect higher inflation, an unchanged money stock will not allow it to happen.
An inconvenient truth is that managing expectations cannot alter economic fundamentals. It turns out that actual impact will be felt even when people are unaware of policy changes. In all events, attempts to guide expectations are undermined by extensive economic illiteracy since most people do not understand the impact of policy changes.
Another worry is that workers will demand higher wages, driving up costs and forcing producers to seek higher prices. If reality worked this way, workers would be able to negotiate higher wages without fear of job loss. And companies would never close since consumers would continue buying as much as ever despite higher prices.
Depicting expectations as a determinant of inflation (or triggering an economic downturn) violates fundamental notions of economics. For example, wage payments are ultimately limited by labour demand that economists describe as a marginal revenue product whereby selling prices constrain wage settlements.
In all events, the truth is that inflationary expectations are not a primary cause of anything. It should be understood that such expectations are caused by loose monetary and credit policy.
If central banks make credit artificially cheap and inflate the money supply, they provide investors with financial means to throw money at highly speculative ventures. In turn, this leads to speculative excesses and rapid growth of asset values since investors tend to miscalculate their future costs. Without the monetary expansion or new bank-financed credit, other transactions throughout the rest of economy must fall in an offsetting manner.
Governments feel compelled to control inflation expectations as a way to manage fiscal risk. As it is, expectations of higher inflation can add to governmental borrowing costs or debt interest payment burdens as investors demand higher yields on bonds. But this will only be temporary if central banks hold the line against inflating the currency.
Expectations expressed by consumers or businesses are only important if their beliefs correspond to economic realities in the future. Rising expectations do not cause “inflation” and have no lasting impact on economic conditions unless accompanied by an excessively expanded rate of growth of the money supply.
Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. Comment at theirview@livemint.com
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First Published: Tue, Sep 09 2008. 12 43 AM IST