The Fog of Inflation

Blogger Jonathan Catalan seems like a pretty pleasant and sensible fellow, and he is certainly persistent. But I think he is a bit too much attached to the Austrian story of inflation in which inflation is the product of banks reducing their lending rates thereby inducing borrowers to undertake projects at interest rates below the “natural rate of interest.” In the Austrian view of inflation, the problem with inflation is not so much that the value of money is reduced (though Austrians are perfectly happy to throw populist red meat to the masses by inveighing against currency debasement and the expropriation of savings), but that the newly created money distorts relative prices misleading entrepreneurs and workers into activities and investments that will turn out to be unprofitable when interest rates are inevitably raised, leading to liquidation and abandonment, causing a waste of resources and unemployment of labor complementary to no longer usable fixed capital.

That story has just enough truth in it to be plausible; it may even be relevant in explaining particular business-cycle episodes. But despite the characteristic (and really annoying) Austrian posturing and hyperbole about the apodictic certainty of its a priori praxeological theorems (non-Austrian translation:  assertions and conjectures), to the exclusion of every other explanation of inflation and business cycles, Austrian business cycle theory simply offers a theoretically possible account of how banks might simultaneously cause an increase in prices generally and a particular kind of distortion in relative prices. In fact, not every inflation and not every business cycle expansion has to conform to the Austrian paradigm, and Austrian assertions that they possess the only valid account of inflation and business cycles are pure self-promotion, which is why most of the reputable economists that ever subscribed to ABCT (partial list:  Gottfried Haberler, Fritz Machlup, Lionel Robbins, J. R. Hicks, Abba Lerner, Nicholas Kaldor, G. L. S. Shackle, Ludwig Lachmann, and F. A. Hayek) eventually renounced it entirely or acknowledged its less than complete generality as an explanation of business cycles.

So when in a recent post, I chided Jon Hilsenrath, a reporter for the Wall Street Journal, for making a blatant logical error in asserting that inflation necessarily entails a reduction in real income, Catalan responded, a tad defensively I thought, by claiming that inflation does indeed necessarily reduce the real income of some people. Inasmuch as I did not deny that there can be gainers and losers from inflation, it has been difficult for Catalan to articulate the exact point on which he is taking issue with me, but I suspect that the reason he feels uncomfortable with my formulation is that I rather self-consciously and deliberately formulated my characterization of the effects of inflation in a way that left open the possibility that inflation would not conform to the Austrian inflation paradigm, without, by the way, denying that inflation might conform to that paradigm.

In his latest attempt to explain why my account of inflation is wrong, Catalan writes that all inflation must occur over a finite period of time and that some prices must rise before others, presumably meaning that those raising their prices earlier gain at the expense of those who raise their prices later. I don’t think that that is a useful way to think about inflation, because, as I have already explained, if inflation is a process that takes place through time, it is arbitrary to single out a particular time as the starting point for measuring its effects. Catalan now tries to make his point using the following example.

[If] Glasner were correct then it would not make sense to reduce the value of currency to stimulate exports.  If the intertemporal aspect of the money circulation was absent, then exchange ratios between different currencies (all suffering from continuous tempering) would remain constant.  This is not the case, though: a continuous devaluation of currency is necessary to continuously artificially stimulate exports, because at some point relative prices (the price of one currency to another) fall back into place —, reality is the exact opposite of what Glasner proposes.  The example is imperfect and very simple (it does not have anything to do with the prices between different goods amongst different international markets), but I think it illustrates my point convincingly.

Actually, devaluations frequently do not stimulate exports. When they do stimulate exports, it is usually because real wages in the devaluing country are too high, making the tradable goods sector of the country uncompetitive, and it is easier to reduce real wages via inflation and devaluation than through forcing workers to accept nominal wage cuts. This was precisely the argument against England rejoining the gold standard in 1925 at the prewar dollar/sterling parity, an argument accepted by von Mises and Hayek. Under these circumstances does inflation reduce real wages? Yes. But the reason that it does so is not that inflation necessarily entails a reduction in real wages; the reason is that in those particular instances the real wage was too high (i.e., the actual real wage was above the equilibrium real wage) and devaluation (inflation) was the mechanism by which an equilibrating reduction in real wages could be most easily achieved. In this regard I would refer readers to the classic study of the proposition that inflation necessarily reduces real wages, the paper by Kessel and Alchian “The Meaning and Validity of the Inflation-Induced Lag of Wages Behind Prices” reprinted in The Collected Works of Armen A. Alchian.

Whether inflation reduces or increases real wages, either in general or in particular instances, depends on too many factors to allow one to reach any unambiguous conclusion. The real world is actually more complicated than Austrian business cycle theory seems prepared to admit. Funny that Austrians would have to be reminded of that by neo-classical economists.

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10 Responses to “The Fog of Inflation”


  1. 1 Mitch January 10, 2012 at 11:02 am

    Krugman has been banging on about why and when devaluation is a good idea for quite some time, especially with regard to the Euro. See for example his article in the NY Time Magazine of a year ago.

    http://www.nytimes.com/2011/01/16/magazine/16Europe-t.html

    He points out that the funamental point was made by Milton Friedman, who explained how difficult it is to negotiate contracts and wages down when they’ve become too high relative to those of other countries.

  2. 3 PrometheeFeu (@PrometheeFeu) January 10, 2012 at 2:03 pm

    I think the main problem when it comes to the conversation on inflation is the lack of distinction between expected and unexpected inflation rates. As long as inflation expectations are met, all my nominal contracts are correct and we all go along happily. But inflation expectations are incorrect, then all my nominal contracts are wrong which means I might be in trouble.

  3. 4 David Glasner January 11, 2012 at 9:45 am

    Mitch, Krugman is certainly right about devaluation and that Friedman made the point long ago. But the point was obviously already familiar in the 1920s and made by Keynes in The Economic Consequences of Mr. Churchill. And Keynes did not claim any originality for his insight.

    Luis, Thanks, glad you liked it.

    PrometheeFeu, Of course, you are right that the distinction between expected and unexpected inflation is absolutely key. I left that distinction implicit when I spoke about ongoing inflation, which I used as a kind of code, for expected inflation. But for some reason, I am not exactly sure why, I preferred not to make the distinction explicit.

  4. 5 Benjamin Cole January 11, 2012 at 7:53 pm

    Right, moderate inflation means I cannot make consumer of investor choices.

    Oh sure, that’s the reason I feel confident in low-inflation environments getting my car fixed, choosing a doctor and insurance plan, buying a house, buying a house, buying stocks, hiring a lawyer and ordering dinner in strange restaurants.

    When inflation is low, I know what I am doing. Let it get up to 5 percent, and I get lost.

  5. 6 David Glasner January 12, 2012 at 8:23 am

    Benjamin, I think that people can adjust to a variety of inflation environments from moderate deflation to moderate inflation. But what people haven’t figured out yet is that how much inflation is needed depends on the underlying real interest rate. Inflation must be greater than the negative of the real interest rate (probably by at least 1.5 to 2 percentage points. The current real interest rate is probably less than negative 1%, so we need at least 3% inflation to get a decent recovery. On the other hand, if the real interest rate were 3%, we could probably do nicely with stable prices or even slight deflation of less than 1%. Those are just very back of the envelope estimates. We would need the econometricians to come up with more precise estimates.

  6. 7 Greg Ransom January 23, 2012 at 10:08 am

    Isn’t the instantaneous (and un-flagged) flip from a dependence on the assumptions of a closed economy to an appeal to a non-closed economy & international monetary economics the biggest cheat in all of Keynesian economics?

    While in the middle of thrashing out the monetary disequilibrium economics of a closed economy, a Keynesian will jump in a Corvette & rocket to the finish line tape by invoking international money relations, even while all of their intervention mechanics depend on the assumption of a closed economy.


  1. 1 The Daily Climb « georgesblogforum Trackback on January 10, 2012 at 4:24 pm
  2. 2 Interpreting Inflation: Revisited | Economic Thought Trackback on January 11, 2012 at 9:02 am
  3. 3 Browsing Catharsis – 01.12.12 « Increasing Marginal Utility Trackback on January 12, 2012 at 5:01 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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