Prices, inflation and growth: our economic commentariat get it wrong again

A few days ago I had an exchange with another brilliant product of one of Australia’s economics departments. This rather conceited young man argued that a little bit of inflation is necessary to maintain economic growth. I tried to get it across to him that inflation is as about as healthy as leprosy. Nevertheless, this young man’s dangerous belief is shared by most of our economic commentariat and this is why one still hears it.

One of those commentators is the renown Terry McCann, no less. This brought to mind his statement of belief that “inflation is not only desirable in its own right. It’s the absolute foundation of sustained growth in the economy and of living standards” (Herald Sun, The prices are right, 9 March 2007). As I recall, McCrann seemed to be coming from one of two positions. The first one was the nonsensical belief that a ‘modest’ rate of inflation is necessary to promote spending and investment. Therefore, without inflation prices would fall which would then curb spending and investment and so depress economic activity. But the idea that any rate of inflation can fuel genuine economic growth is utterly absurd, unless one believes in the ‘beneficial effects’ of “forced saving”.

Jeremy Bentham was, I believe, the first economist to outline the forced saving doctrine (the process of using inflation to restrict consumption in order to raise the rate of capital accumulation)  which he called “Forced Frugality”. (A Manual of Political Economy, written in 1795 but not published until 1843, p. 44). Thomas Malthus, his contemporary, pointed out the dangers and injustice of “forced savings”. (Edinburgh Review, February 1811, pp. 363-372.)  John Stuart Mill described the process as one of “forced accumulation” and condemned it with the statement that accumulating capital by this means “is no palliation of its iniquity”. (John Stuart Mill, Essays on Economics and Society, University of Toronto Press 1967, p. 307).

In the early to mid-1720s Richard Cantillon, an Irish banker living Paris, produced a brilliant work of sophisticated economic analysis that vividly described how inflation distorts the pattern of production and causes a redistribution of incomes and wealth. (Essay on the Nature of Commerce in General, Transaction Publishers, 2001). It was this essay that gave us the concept of the “Cantillon effect”. Yet not a single member of our economic commentariat appears to have the slightest acquaintance  with this invaluable work. It’s not even as if Cantillon’s opinion that money is not neutral is eccentric.

The same vital point that Cantillon made was also stressed by Peter Lord King and Henry Thornton et al. On the other hand, David Ricardo and John Wheatley (both of whom, like Lord King, were bullionists) argued that the effect of increases in the money supply on prices was strictly proportional. Hence a 10 per cent increase in the money supply would raise prices by the same amount. Nevertheless, Ricardo1 and his supporters understood that increasing the stock of money did nothing to improve the general welfare. As Ricardo himself put it:

The successive possessors of the circulating medium have the command over this capital: but however abundant may be the quantity of money or of bank-notes; though it may increase the nominal prices of commodities; though it may distribute the productive capital in different proportions; though the Bank, by increasing the quantity of their notes, may enable A to carry on part of the business formerly engrossed by B and C, nothing will be added to the real revenue and wealth of the country. B and C may be injured, and A and the Bank may be gainers, but they will gain exactly what B and C lose. There will be a violent and an unjust transfer of property, but no benefit whatever will be gained by the community. (The High Price of Bullion, a Proof of the Depreciation of Bank Notes, Printed by Harding & Wright, St. John’s square, 1810, 49*).

 Naturally our current crop of sophisticated economic commentators would dismiss all of the above as old fashioned stuff and nonsense that has been discredited by modern economics. (A dismissive approach always beats having to debate anyone). According to these economic pundits a steady increase in the money supply is necessary if production is to be expanded. Oddly enough, this thinking is strictly mercantilistic though the renowned David Hume2 also subscribed to it. (David Hume, Essays, Moral, Political, and Literary, William Clowes and Sons, Limited 1904, p.296.) Edward Misselden and Thomas Mun were 17th century mercantilists who believed that “treasure” would stimulate production if allowed to circulate. For example, Mun wrote:

[W]hat shall we then do with our mony? the consideration of this, doth cause divers well-governed States to be exceeding provident and well-furnished of such provisions, especially those Granaries and Storehouses with that famous Arsenal of the Venetians, are to be admired for the magnificence of the buildings, the quantity of the Munitions and Stores both for Sea and Land; the multitude of the workmen, the diversity and excellency of the Arts, with the order of the government. They are rare and. worthy things for Princes to behold and imitate; for Majesty without providence of competent force, and ability of necessary provisions is unassured. (England’s Treasure by Forraign Trade. or The Ballance of our Forraign Trade is The Rule of our Treasure, published for the Common good by his son John Mun of Bearsted in the County of Kent, Esquire, 1664, Macmillan & Co, 1895, p, )

 Proto-Keynesians like Misselden and Mun believed that the more gold in circulation the greater would be a country’s prosperity. This thinking is but a single step from the doctrine that a little inflation is good for a country. It was a step that both men enthusiastically took, with Misselden cheerfully declaring:

And for the dearnesse of things, which the Raising of Money bringeth with it, that will be abundantly recompensed unto all in the plenty of Money, and quickning of Trade in every mans hand. And that which is equall to all, when hee that buye’s deare shall sell deare, cannot bee said to be injurius unto any. And it is much better for the Kingdome, to have things deare with plenty of Money, whereby men may live in their severall callings: then to have things cheape with want of Money, which now makes every man complaine. (Free Trade or, The Meanes To Make Trade Florish, Printed by John Legatt, for Simon Waterson, 1622, p. 106.)

 Perhaps the greatest proto-Keynesian of them all was John Law. It was his proto-Keynesian belief that money stimulates trade, though he clearly understood that the value of money was determined by its quantity and demand. His error was to make employment a function of total spending which in turn was determined by the quantity of money, as is evident in the following quote:

Domestic trade depends on the Money. A greater Quantity employs more People than a lesser quantity. A limited Sum can only set a number of People to Work proportioned to it, and ’tis with little success Laws are made, for Employing the Poor and Idle in Countries where Money is scarce : Good Laws may bring the Money to the full circulation ’tis capable of, and force it to those Employments that are most profitable to the Country : But no Laws can make it go further, nor can more people be set to Work, without more Money to circulate so as to pay the Wages of a greater number. They may be brought to Work on Credit, and that is not practicable, unless the Credit have a Circulation, so as to supply the Workman with necessaries; If that’s suppose’d, then that Credit is Money, and will have the same effects, on Home, and Foreign Trade.(Money and Trade Considered,  R & A foulis, 1750, p. 20).

 Sounding like a graduate of Chicago University he argued that there could be no inflation so long as the increased output kept in step with an expanding paper money. However, he did warn that a rise in nominal incomes could cause an increase in the demand for “Forreign Goods”.  What Law apparently did was confuse the immediate effects of monetary expansion with its longer term effects. To cut the story short, Law’s monetary policy caused a massive boom that devastated the French economy. Consequently he was forced to leave the country, dying in poverty and exile in 1729.

The current orthodoxy that McCrann unthinkingly clings too brings to mind a 1952 article by Sumner H. Slichter (a Harvard professor) that was published in Harper’s Magazine. Calling the article How Bad is Inflation Slichter contended that a price level of 2 to 3 per cent is essential for prosperity. However, Dr Winfield Riefler of the Federal Reserve pointed out at the time, even if an inflation rate of 2 per cent a year could be controlled “it would be equal to an erosion of the purchasing power of the dollar by about one-half in each generation”. But as I said earlier in the piece, there would be no uniform change in prices, meaning that inflation distorts, as Cantillon explained, the pattern of production and incomes. This fact moved Gottfried Haberler to write:

… the process of inflation always leaves behind it permanent or at least comparatively long-run changes in the volume of trade and in the structure of industry. The impact effect is a change in the direction of demand. At he points where the extra money first comes into circulation purchasing-power expands; elsewhere it remains for a time unchanged. (The Theory of Free Trade, William Hodge and Company LTD, 1950, p. 54, first published 1933).

Readers are probably aware of the fact that Milton Friedman was also of the opinion that a steady increase in the money supply was necessary to stabilise the price level and to prevent recessions from emerging. Yet the very same Friedman could write that

[T]he price level fell to half its initial level in the course of less than fifteen years and, at the same time, economic growth proceeded at a rapid rate. The one phenomenon was the seedbed of controversy about monetary arrangements that was destined to plague the following decades; the other was a vigorous stage in the continued economic expansion that was destined to raise the United states to the first rank among the nations of the world. And their coincidence casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible. (Milton Friedman and Anna J. Schwartz, A Monetary History of the United States 1867–1960, Princeton, N.J.: Princeton University Press, 1971, p. 15).

Of course this is not the kind of opinion that will not influence those who think like McCrann. And why should it when Friedman ignored his own evidence in favour of ‘controlled inflation’? Nevertheless, seeing, as they say, is believing. For those of you who still remain uncertain about the relation of economic growth to the money supply, the following charts provides ample historical evidence that neither economic history nor sound economics supports the fallacy that inflation drives promotes economic growth.

The charts were taken from S. B. Saul’s The Myth of the Great Depression:1873-1896 (Macmillan Publishers LTD, 1969). The first one clearly shows prices falling from about 1874 to 1896. This was a productivity-induced price change. Now what matters for the businessman is not the price of his product as such but his price margin. In the absence of an inflationary policy additional investment embodying new technologies will lower marginal costs thus increasing labour productivity. The result will be increased output, falling prices, a continual rise real wages and, at the very least, the maintenance of price margins3. Unlike today’s crop of economists, classical economists were very much aware of this fact. Therefore, to describe this period as one of deflation is to commit a gross error. The second chart leaves no doubt that productivity increases led to a steady increase in real wage rates until about 1900.


I think I shall leave the final word to the late Lionel Robbins:

The history of economic thought has a twofold function; to explain the past and to help us to understand the present. By examining the economic theories of the past we can learn to see the problems of earlier times, as it were, through the eyes of their contemporaries. By comparing them with the theories of the present we can realize better the implications and the limitations of the knowledge of our own day. (Chi-Yen Wu, An Outline of International Price Theories, George Routledge and Sons LTD, 1939, p. xi)

1Ricardo actually acknowledged that monetary expansion can distort the capital structure and incomes. (The High Price of Bullion, p. 49).

2Hume contradicted himself. On page 294 he points out that the a gold inflow is only favourable until prices rise. However, also observes that money is not neutral. The passage was pregnant with possibilities that he failed to see.

3Austrians stress the danger of monetary policies designed to stabilise the price level.

14 thoughts on “Prices, inflation and growth: our economic commentariat get it wrong again”

  1. That was damned interesting but you have to go up more often. I was starting to think you were finished

  2. Jerry.

    I hope you are not saying the current deflationary come disinflationary problems we are experiencing world wide are associated with productivity improvements.
    Deflation is usually associated with depressions.
    I concur deflation when it is the result of productivity improvements is not a problem but that is the exception not the rule.

    Inflation is a great thing when experiencing a depression. Ralph Hawtrey and Keynes were in agreement on that. It meant there was no longer a liquidity trap and thus monetary policy could be the main driver of economic policy. Something else they agreed on . It is why Hawtrey loved large devaluations.

  3. I learnt quite a bit from the article but it’s just no good going up now and then. Unless you go up at least 5 times a week the only thing we will get is bloody Davidson and his mates.

  4. I understand the complaints about not posting often enough and I agree that they are justified. By the end of the month I expect a great improvement in the situation.

  5. Nottrampis

    My basic point is that real deflations are a monetary phenomenon. Therefore a productivity-induced fall in general prices is not a deflation and no steps should be taken to reverse the process. Austrians continually point out that any policy to stabilise the price level lays down the foundations for another recession.

    You say that inflation “is a great thing when experiencing a depression”. But inflation (or reflation) always followed a recovery under the classical gold standard, which was really a quasi-gold standard. It could not be otherwise because of the fractional banking system. Under the current fiat system there have been no true deflations.

    As for the liquidity trap, I consider it to be a Keynesian fiction. Interest interest does not spring from the supply of and the demand for money. Furthermore, the classical economists were fully aware of so-called ‘liquidity’ problems (the increase in cash balances) that attended depressions and quite rightly thought them natural. This is because they also made the correct distinction between an increase in savings and a sudden increase in the demand to raise cash balances. In other words, they understood that the demand for cash balances was unrelated to the rate of interest.

    I think if you follow the link you might get a reasonably good idea of where I am coming from.

    Incidentally, it is a pleasure to encounter someone who prepared to engage in a civil and informed exchanged. It is to be deeply regretted that the same cannot be said of our self-appointed free market right.

  6. Im glad to hear you will start posting more often. Yours is the only Aussie blog that gives any real economics. You explain things while the Catallaxy mob just spouts off. You proved they don’t even know any history.

  7. What a difference between Nottrampis and John Humphreys. Nottrampis comes to the site in a gentlemanly and civil fashion while Humphreys shows up as an arrogant lout. My God, what can one really say about our right.

  8. Gerry,

    I think a liquidity trap is merely when monetary policy doesn’t work.

    If prices are falling at say 5% then interest rates cannot fall below 0% hence a liquidity trap.
    During the GFC if you took a forward looking taylor rule then interest rates had to be at -5% which again shows a liquidity trap.

    Does this help or do you simply disagree with this ‘definition’?

    By the way I will put this in my Around the Traps on Friday

  9. Nottrampis

    I stick with my original view that the liquidity trap is a fiction.

    Now I did try to stress that there is a fundamental difference between a productivity-induced fall in the price level and a money-induced fall.

    As for the Taylor rule, no Austrian could possibly support it.

    You have raised important points. However, I think you will agree that these simply cannot be dealt with in brief exchanges. I’m sure any attempt to do so would only frustrate those readers who have little or no knowledge of the subject.

    May I therefore suggest that you contribute a post detailing your views on this matter. In turn, I would fully state my position. I think readers would find this more satisfactory and instructive than brief exchanges. After all, these are important issues.

    I hope you find my suggestion agreeable.

  10. Hi Jerry sorry for the late reply.

    I am a little reticent on writing anything here. This is an Austrian based blog and I am an eclectic Keynesian and I have no wish to stir up blood which perhaps may turn bad.
    A liquidity trap is merely when monetary policy doesn’t work.
    Thus if a country is in a depression and prices are falling 5% and interest rates cannot fall below 0% then voila a liquidity trap.

  11. Nottrampis

    There is absolutely no reason to be reticent. We are only interested in honest and open debates. That’s why we don’t allow abusive comments and profanities. We honestly believe economic problems and ideas need to be discussed in the open arena. If people don’t get the full story how in heavens name are they supposed to assess the arguments?

    Our criticism of the right is exactly the same as yours: they adamantly refuse to debate the issues. What is even worse, they make ex cathedra statements and then virtually demand that they be accepted without question. These statements then become the Party Line.

    We find this attitude deeply offensive and even dishonest. In fact, it is their one-sided mind-set that brought this site into existence. Ours is an attempt to encourage what they refuse to support and that is a genuine discussion of of ideas.

    Finally, so long as people act in good faith, they are welcome.

    BTW, my article on the 1937-38 crash got held up. Fortunately it will be up next Monday at the latest.

  12. Mr. Jackson, I hope you are still monitoring these comments. Thank you for the wonderful article. I just have one question. The upper graph of the two you show is labeled “Wholesale prices in Britain 1815 – 1813 (1900 = 100)”. Is that supposed to read, instead, “1815 – 1913”?

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