Economics and Price Inflation

While some Austrian school economists predicted the housing bubble, many have not been as accurate with their prediction of price inflation, or at least not yet.  This is the danger of making predictions.  It gives a little ammunition to people like Paul Krugman.  The ironic thing is that Austrian (free market) economics should make us careful in making bold predictions.  Austrian economics teaches that economics is really the study of human action and human action cannot be predicted with certainty.

So what has happened with price inflation?  While many claim that it is understated in the government statistics and they may have a valid claim, it is obvious that price inflation has not been severe.  We are not anywhere near the 1970’s, or at least not yet.

Milton Friedman said that inflation is always and everywhere a monetary phenomenon.  This is essentially correct with a long-term view.  However, in the short term, it is more than just monetary policy that dictates consumer price inflation.

One thing that is important to note is that inflation is not uniform.  Monetary inflation can cause pockets of high price inflation and it doesn’t just have to be in consumer goods.  It can also be in stocks, bonds, gold, or any number of other things.

There are basically three things that will affect overall consumer prices.  One is the money supply.  Two is velocity, or the demand for money.  Three is fractional reserve lending.

Actually, number three really fits in with the first two.  Velocity can drive the degree of fractional reserve lending and the degree of fractional reserve lending affects the money supply, at least in a sense.  While the actual supply of money doesn’t increase with fractional reserve lending, it gives multiple people the claim on the same money.  Therefore, the actual digital bank accounts of people and companies are higher than they would be without fractional reserve banking.

I say that velocity affects fractional reserve lending and we can see that with the current situation.  The commercial banks have built up massive excess reserves over the last 4 years and it is not because their reserve requirements have gone up.  Due to the hard economic times, there is more demand for money. In other words, velocity has slowed down considerably.  People are scared and are trying to build up cash reserves and pay down debt.  The same goes with businesses.  The banks are also scared of making bad loans and would rather sit on the money than risk lending it out.  So the overall recession and the scary economic times have slowed velocity and built up excess reserves.

This is what was missed by people who predicted imminent and severe price inflation.  The Federal Reserve has tripled the adjusted monetary base since the fall of 2008, yet we have not seen a corresponding increase in overall prices.  I believe this is due to the high excess reserves, which prevented another de facto increase in the money supply from fractional reserve lending and I believe it is also due to the low velocity.

When there is a higher demand for money, this is the equivalent of lowering the money supply.  Therefore, an increase in the money supply can be offset by a higher demand for money.  The Fed can control the money supply.  It has a certain amount of control over excess reserves with its policies.  The Fed has far less control over the demand for money.  However, I won’t say that the Fed can’t affect the demand for money at all, because it could if it went crazy enough with money creation.  The Fed could also cause velocity to drop even more if it stopped buying government debt.

Unemployment is high and people are still spooked from 2008 and rightly so.  Therefore, they are paying down debt and trying to build up cash (or the equivalent of cash in their bank accounts).  This means that they are spending less.  This means they are not bidding up prices as much.  It means that the higher money supply is being offset by a higher demand for money.

This is the reason that we have not seen high price inflation.  It is possible that it could continue and it is possible that it could reverse quickly.

In my next post, I will discuss the possibilities of price inflation with excess reserves remaining high.