Crying Wolf on (Hyper)Inflation?
[This article is part of the Understanding Money Mechanics series, by Robert P. Murphy. The series will be published as a book in 2021.]
In chapter 10 we explained the connection between monetary inflation and price inflation, and warned that there is no simple one-to-one relationship. This fact has been very relevant in the wake of the various rounds of quantitative easing (QE) that the Federal Reserve implemented after the financial crisis of 2008. The following chart shows the huge increase in the monetary base since 2008:
In the early years of QE, many economists—including the present author1—warned that the Fed’s unprecedented monetary inflation would cause a significant increase in consumer prices. Some pundits went so far as to warn of actual hyperinflation, reminding Americans of the terrible experiences of Weimar Germany and modern Zimbabwe. Yet years passed by without the “inflation time bomb” exploding. This led the proponents of the Fed’s policies to mock the warnings as crying wolf.
In this chapter, we’ll assess several popular explanations for why the Fed’s monetary inflation since 2008 hasn’t generated a comparable increase in price inflation. Because this book is intended to be educational rather than polemical, we will merely mention some of the pros and cons for each possibility, rather than arguing which are correct and which should be rejected.
“The government’s CPI measure vastly understates price inflation.”
The benefit of this type of explanation is that it focuses proper cynicism on data produced by government agencies, which are not renowned for their unwavering devotion to truth.
However, the problem with this explanation is that many critics of QE were warning of significant price inflation that could not have been hidden through statistical tricks. Americans were able to fill up their vehicles in 2010 (say) and for most drivers the price was $3 or less per gallon of gasoline. If some of the more serious warnings of price inflation had proved correct, this would not have been possible.
Keep in mind that the official government measures showed twelve-month CPI (Consumer Price Index) inflation hit a whopping 14.6 percent in March 1980. Had the government told Americans at that time that inflation were under 2 percent, it would have been an obvious lie. So although the conventional measures may be significantly understating the rising cost of living since 2008, the mismatch between the extreme warnings and reality can’t be explained entirely by reference to data fudging.
“Inflation won’t be a problem while we still suffer from an output gap / idle resources.”
According to both Keynesians and proponents of MMT (modern monetary theory), increased government spending—even if financed by monetary inflation—won’t generate large increases in consumer prices so long as the economy is operating below its capacity. In more technical terms, they argue that so long as real GDP is below potential GDP, increases in nominal spending serve to boost real output rather than prices. The intuitive idea is that the unemployed and other idle resources will absorb new spending first, before tightening labor and resource markets cause wages and other prices to begin rising.
On the plus side, the Keynesians and MMT camp were correct when they said the various rounds of QE since 2008 would not cause extreme price inflation, let alone hyperinflation. Since some of their opponents did predict such a result, the Keynesians and MMTers can understandably claim vindication.
However, there are numerous problems with this explanation. For one thing, the Keynesians didn’t merely predict a lack of significant price inflation; many of them predicted price deflation. For example, Paul Krugman in a blog post in early 2010 posted a graph of collapsing CPI inflation, warned that the disinflation could soon turn to outright deflation, and ended with, “Japan, here we come.”2 (Japan had experienced sustained reductions in CPI.)
Five months later, Krugman admitted that the standard Keynesian tool of the Phillips curve—which models a tradeoff, at least in the short run, between unemployment and (price) inflation—hadn’t worked so well in the aftermath of the financial crisis. As Krugman acknowledged in a post entitled, “The Mysteries of Deflation (Wonkish),” coming into the Great Recession, “the inflation-adjusted Phillips curve predict[ed] not just deflation, but accelerating deflation in the face of a really prolonged economic slump” (italics in original).3 And since that hadn’t happened, the Keynesians too had to tinker with their model in light of reality. To generalize, in 2009 the conservative economists had predicted accelerating inflation, while the progressive economists had predicted accelerating deflation.
Another serious problem with the no-inflation-until-full-employment doctrine is that it was disproved in the so-called stagflation of the 1970s. The Keynesian mindset of the postwar era had originally led policymakers to believe that they had to choose between either high unemployment or high inflation in consumer prices. It should not have been possible for the economy to suffer through both evils at the same time.
And yet, once Richard Nixon killed the last vestiges of the gold standard in 1971 (which we explained in chapter 3), the remainder of the decade saw unusually high levels of both. For example, in May 1975 the unemployment rate was 9 percent while the twelve-month change in CPI was 9.3 percent. In light of the US experience of the 1970s, simple rules such as “the economy can’t overheat while there are still idle resources” can’t be the full story.
“Yes, the money supply increased dramatically after mid-2008, but the demand to hold it increased as well.”
On the plus side, this explanation is necessarily correct; every fact about prices can be handled in a supply-and-demand framework. The “price” of money refers to its purchasing power; how many units of goods and services can a unit of money fetch on the market? If we hold the demand for money constant and vastly increase its supply (through rounds of QE, for example), then the “price of money” falls, meaning the currency becomes weaker, meaning that the prices of goods and services quoted in that money go up. This is of course just another way of describing price inflation.
However, in practice other things might not remain equal; the demand for money might increase too, especially during a financial crisis. Remember that th
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