Paul Krugman and the Austrians go at it over inflation. He scores a run but loses the game.

 

Published on 21/7/14 Paul Krugman takes on the Austrians over inflation

 

Let’s look at the underlying issue. Mainstream economists define inflation as something along the lines of “a general increase in prices and fall in the purchasing power of money”. There are many different ways to measure this, but for our purposes we will stick to the most common measurement, the Consumer Price Index (CPI).

 

The consumer price index measures changes in the price of a market basket of consumer goods and services purchased by households.

 

Actually measuring the CPI is quite difficult. It sounds simple to take a market basket of goods in one year and then measure the price of those same goods the next year, but that does not really represent the true experiences that consumers felt during the course of the year. For example, consumer preferences change during the course of the year. At the end of the first year consumers might be purchasing a different basked of goods merely because there preferences have changed. Or, beef prices might have gone up during the year by 20%, but consumers might not have experienced such a hit because they switched to an alternative instead. Additionally, products get better over time. TV prices might have gone done 10% during the course of the year, but at the same time it’s not the same TV being purchase. This one is even better than the common model made the year before.

 

Of course the government attempts to deal with this, but the overarching point is that CPI is a difficult number to calculate and then to interpret what it really means to the average household.

 

On top of that, there are many who allege that the government fudges the numbers and that inflation is running far higher than the official government statistics. The publisher of www.shadowstats.com takes such a view and offers his alternative data as a subscription service.

 

The Austrian School of Economics sees things differently. The Austrian School of Economics defines inflation simply as an increase in the money supply. The logic behind this is simple: If you have X number of dollars chasing Y number of goods, then by definition if you increase X while keeping Y stable, each unit of X has less purchasing power.

 

This actually coincides nicely with the second part of the mainstream definition above: “.. fall in the purchasing power of money”. That an increase in the money supply leads to a fall in the purchasing power of money is simply a mathematical certainty.

 

So where exactly is the discrepancy between mainstream economists and Austrians? The discrepancy lies in what is being measured. Mainstream economists are simply measuring a basket of household goods. Austrians are measuring the overall purchasing power of the dollar in the economy. Why is there a difference? Because the nature of inflation has changed since the world has gone completely to fiat currencies.

 

Inflation has a long history. Since man first minted coin, those who control those coins have sought to de-value them in order to capture wealth for themselves.

 

The Roman Emperors routinely devalued the currency. In one famous incident the emperor devalued the Denari from 84 Denari per pound of silver to 96 Denari per pound of silver. The result of course was that the Emperor was able to simply spend more money at the expense of everyone else in Rome. (in other words, there was an increase in X despite Y staying the same). As a result there was a general price inflation.

 

It’s important to ask however how this extra money entered the system. It entered through purchases by the emperor of goods and services. In that manner the price of goods and services increased.

 

Had there been mainstream and Austrian economists observing at the time, there would have been little divergence between the increase in the money supply and the increase in general prices.

 

This relationship would stay true for close to 2,000 years. It all changed however in the 1980’s.

 

The 1970’s saw a general price inflation as the Nixon administration printed money in order to fund excessive government spending (Yes, I know that the government doesn’t technically print the money, but for purposes of this analysis it is the same thing). Money was created and it was channeled into goods and services. General prices rose. The people were angry. Part of the problem was also the idiotic belief by mainstream economists that inflation was good for employment (due to their belief in the misguided Phillips Curve). The print and spend polices continued into the Carter era and helped contribute to his defeat.

 

There was to be no more inflation after that. The people wouldn’t stand for it, and if the people won’t stand for it then the government won’t stand for it either less the next election turn out poorly.

 

Enter the Fed and Wall Street. The Greenspan discovered (whether accidentally or on purpose) that by making the rate at which banks accessed money artificially low, the banks would ultimately channel those dollars into asset purchases, and lending to people who purchased such assets. Furthermore, it was made clear that if those assets declined in value that the banks in general (if not a few specific ones) would be bailed out. This was the beginning of the boom and bust asset cycle that we still see today.

 

As the printing press was turned on in the 1980’s Austrians bemoaned loudly that inflation or even hyperinflation was coming. However looking at CPI it never really came (or at least not at the dire levels predicted). What happened instead was the asset bubbles which is turns out the people don’t have such a problem with as long as they participate in some manner.

 

So back to Krugman: Krugman correctly understands that there is simply a difference in the definition of inflation between mainstream and Austrian economists. He does however raise a good point saying “So when Austrians were predicting runaway inflation, they didn’t actually mean consumer prices”?

 

He has a good point. Many if not most Austrians failed to predict the way that the newly printed would be channeled into narrow asset classes. While Austrian economists understand this today, many casual followers still do not.

 

All the being said though, the Austrians are still correct in their measure of inflation. Each dollar today has seen a dramatic “fall in purchasing power”. Even if the fall and purchasing power for groceries is not that great, it certainly is for most assets, particularly financial assets which are not properly covered by the CPI