What is inflation? The answer seems obvious: When things get more expensive, that’s inflation, which is bad. But an alternative view is that of Milton Friedman. In a 1963 talk, the highly influential economist defined inflation as “a steady and continuous rise in prices” and added that “inflation is always and everywhere a monetary phenomenon.”
The distinction is important. Consider two scenarios that might illustrate this. In each, consumer prices have risen 10 percent over the past year.
In the world of inflation, there is a lot of money around. Everything increases in cost at the same rate, including labor. With your wages rising at the same rate as prices, the situation is a bit confusing and uncomfortable, but it’s not a crisis. The main danger is that inflation becomes self-sustaining, and the main responsibility for solving the problem lies with the central bank.
At Energy Crunch World, the cost of energy has doubled. About 10 percent of the expenditure is used for energy; That’s now about 20 percent. At Energy Crunch World, the consumer price index is still rising by 10 percent, and all the respected correspondents describe the situation as “10 percent inflation,” just as it is in global inflation. But the price increase is not “constant”. It is not widespread and unlikely to be “sustainable”.
The risk of a self-sustaining power shock is small. It’s hard to imagine that we’ll spend 30 percent of our income on energy next year, 40 percent the year after, and 50 percent the year after that. But the damage is bad enough; Rather than being a little confusing, this is a crunch. The basic necessity has become unsustainable for many.
In the world of inflation, things only seem more expensive because price tags are constantly changing. This is inflation. In Energy Crunch World, things are really more expensive. I dare point out that this is not hypertrophy – it is much worse.
The same distinction applies when things get cheaper thanks to technological advances. Music is much cheaper than it used to be, as are laptops and solar panels. And by “cheaper” I don’t mean in the almost nonsensical sense that there are fewer numbers on the price tag. I mean cheaper in the only way that really matters, which is that it requires fewer resources to produce and therefore is within the reach of more people.
Perhaps I am doomed to fail in my project to separate real price changes from inflation. The real world, of course, contains elements of both, so confusion is inevitable. We are dealing with a temporary but very painful increase in the real cost of energy and food, as in Energy Crunch World, but we have also seen loose money and broader price increases, as in Inflation World.
But the two sources of higher prices require very different policy responses. In the world of inflation, inflation is a monetary phenomenon and needs a monetary response such as higher interest rates. At Energy Crunch World, the rise in prices needs a realistic response in the form of support for struggling households, every effort to reduce demand and to find new sources of supply.
Look around and you will see a lot of confusion on this point. In the United States, the recently signed Inflation Reduction Act is nothing of the sort. It promises to squeeze expensive drug prices, give tax credits to low-carbon energy sources and tighten some tax loopholes. These are promising policies, but if successful, they will work by improving the structure of the real economy, not by tightening monetary conditions.
The same reasoning applies to US proposals to tighten competition policy. If a monopoly is dismantled and its fat gains reduced, the result should be lower prices and increased incentives to improve quality and increase service. That should mean a one-time boost in real living standards, arguably far more important than any effect on inflation. If it affects inflation at all, it would be a temporary picture – and “lowering inflation” was not, and should not be, the test of competition policy.
Or consider the idea of a universal basic income. It is often attacked as inflationary, but there is nothing particularly inflationary about raising taxes and using money to fund basic income. The case against basic income has nothing to do with inflation: it’s that those high taxes plus the availability of unconditional cash can create too much disincentive to work for a lot of people.
Friedman was oversimplifying when he declared that inflation was always and everywhere a monetary phenomenon. But the statement is not entirely wrong and has very clearness. If you try to evaluate clean energy subsidies, support for cutting-edge research, competition policy, or tax reform through the lens of eliminating inflation, you miss the point. These policies stand or fall on their real-world advantages.
Meanwhile, the best long-term inflation forecast is that after five years, the rate of inflation will be what independent central banks want it to be. Even if elected governments can help, they have plenty of serious economic problems to keep them occupied. Maybe they should start there.
Written for and first published in the Financial Times on September 16, 2022.
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