Don Boudreaux, a professor of Economics at George Mason University and senior fellow at George Mason’s Mercatus Center, discusses inflation: what it means, its cause and effects, and how it can be whipped.

By Reuvain Borchardt

Let’s begin at the beginning: What is inflation?

The modern definition of inflation is a decrease in the purchasing power of the currency. But it’s important to understand that this doesn’t mean the dollar has a lower ability to purchase just one or two particular goods — for example, if the price of only gasoline rises, that doesn’t necessarily mean there’s a general decline in the purchasing power of the dollar. Inflation is a general decline in the purchasing power of the dollar. It’s the flip side of a rise in all prices and wages. It’s a decline in the value of the currency relative to the goods and services that that currency is used to purchase.

If that’s the “modern definition,” what’s the old definition?

A hundred or more years ago, the standard definition of inflation was an increase in the supply of money, relative to the willingness of people to hold money. So if the central bank, or the Treasury, or whoever was in charge of controlling the money supply, increased the money supply, that increase itself was called inflation. That increase always led to an increase in all prices and wages. So the consequence of the original meaning of inflation — a general rise in nominal prices and wages, meaning a general decline in the purchasing power of the currency — has since become the definition of inflation.

So the original definition was the cause, while the modern definition is the effect?

Yes, that’s a fair enough summary.

Let’s go with the modern definition. Does it matter why the purchasing power of the dollar has decreased? For example, some people, particularly on the Right, will blame high prices on the stimulus bills producing an overabundance of dollars. Others, particularly on the Left, will blame the high prices on supply-chain bottlenecks caused by the pandemic. Either of those two causes would result in too much money chasing too few goods. But does the question of whether the situation would be deemed “inflation” hinge on the cause?

On the most general level, no. On the most general level, anytime you get an increase in the amount of money compared to the amount of goods and services that that money buys, you’re going to get an increase in the price level, what we today call inflation.

Prof. Don Boudreaux

But there’s an important difference that a lot of people forget. Inflation is sort of a term of art. When we use this term as it’s recently been used, certainly during the post-World War II era, it means not just a rise in the general price level, but a rise in the general price level that’s sustained and continuing — that the prices are going up month after month, year after year; it’s not just a one-time jump.

A supply-chain disruption caused by a war, a pandemic or a natural disaster can cause a rise in the price level by making all goods and services more scarce than they were before. But it only happens once. If we witness month after month after month, and certainly year after year after year, a continuing decrease in the purchasing power of the currency that cannot plausibly be explained by disruptions in the supply chain, natural disasters, weather problems or wars — that’s caused by recklessness with the money supply. Ultimately, inflation is caused by an increase in the supply of money relative to the amount of goods and services out there. Milton Friedman, the most famous monetary economist who’s ever lived, famously said, and I think he was correct, “Inflation is always and everywhere a monetary phenomenon,” meaning if we witness a sustained increase in price levels, you can bet that behind it, if you trace back the causes, you will find an excessive growth in the supply of money relative to the supply of goods and services.

If there were a decrease in the goods and services available, for example because of a war or a supply-chain bottleneck, should the Federal Reserve decrease the money supply so that prices remain stable?

If the sole goal is to avoid an increase in the price level, then yes, that’s what it should do.

But I wouldn’t really recommend that as a policy, because it’s very difficult for a central bank to know exactly the extent to which supply chains are disrupted, and for how long those disruptions will last, and how they will play out. In the event of supply-chain disruptions, I would argue you should let all the prices rise, because those price increases will signal something real — that there is something bad happening in the world, like a pandemic or a war, and there’s a real disruption in the supply chain, and we have to deal with these higher prices. So if there are general price increases caused by something like a supply-chain disruption, I’m in favor of letting that price increase run its course, because that’ll signify to people that there’s a shortage of goods, whereas cutting the money supply to keep prices stable would mute that message.

The Federal Reserve generally wants to keep inflation at a 2% rate. Why is 2% preferred, as opposed to 0%?

I have never understood that.

If you get down into the formal economic weeds of it with the economists on the Fed who support that position, they would say something along the lines of: “We know historically that prices and wages are ‘sticky downward,’ meaning that when demand in certain sectors fall for goods or labor, the prices and wages don’t fall enough in order to relieve the resulting unemployment. So if you have a small amount of inflation regularly, the inflation will eventually eat away at the sticky prices, and will cause the ‘real price,’ which is the cost when adjusted for inflation, to fall, even though the number you see on the price tag, known as the ‘nominal price,’ doesn’t fall.”  I think that’s what most of those economists would say. But I disagree.

Economist Milton Friedman appears at a news conference at the Mayflower Hotel in Washington in connection with the American Conservative Political Action Conference, Feb. 14, 1976. (AP Photo/Peter Bregg)

Let me pause to mention that my economic specialty is not monetary economics. My specialties are trade and antitrust. But I studied monetary economics many years ago from one of the greatest monetary scholars, Leland Yeager. And I have never understood this notion that the optimal rate of inflation is anything other than zero. I don’t understand why people think we need to have a positive rate of inflation.

In the United States from the end of the Civil War until the very early part of the 20th century, for about 35 years we had a period of sustained deflation. The price level every year either stayed the same or fell. The purchasing power of a dollar in 1901 was higher than it was in 1868. And that was a period of enormous economic growth. We were then under a classical gold standard, so the dollar supply couldn’t grow very much. We had an enormous increase in the output of goods and services, it was a period of great industrialization, so the growth in goods and services relative to the amount of money that was circulating caused the purchasing power of the dollar to fall — and it didn’t cause any great calamities. There were, of course, some economic downturns during that time. But scholars such as George Selgin and my colleague Larry White have identified those downturns during that 35-year period as being caused not by the deflation itself, but largely by unwise banking regulations, such as restrictions on branch banking.

Well, right now inflation is higher than even the most dovish member of the Federal Reserve Board would like it to be. For the year ending March 2022, the Personal Consumption Expenditures price index is up 6.6%, and the Consumer Price Index has risen 8.5%. Of course, some goods are affected more than others.

When there is inflation, in the long run the price of all goods should rise by the same amount. But, of course, in the short run they don’t, because the world is an imperfect place, and different prices are more responsive than other prices.

In a world without inflation, when you see the price of a good or service rising, if you’re an entrepreneur you know that that good or service has become more scarce, so it might be very profitable for you to enter that industry. But in a world with inflation, if you see the price of a particular good or service rise, you don’t know if it’s caused by inflation or by the fact that consumers really want it more intensely than they wanted it before. This uncertainty is an unappreciated cost of inflation — that inflation distorts the market’s ability to signal to businesses and investors and entrepreneurs where it’s best to put their efforts and resources. In a world without inflation, the signals are much clearer—the falling prices and rising prices tell you something. But in a world with inflation, you don’t know so much what they mean.

So let’s look at one particular product — gasoline. People are complaining about the prices at the pump. And I have no doubt that part of that price rise is due to Putin’s invasion of the Ukraine, which is spooking futures markets and disrupting the ability of global petroleum markets to keep up the supply of petroleum. That has made gasoline become more scarce, so prices are rising. So to the extent that the price of gasoline is rising because of the war in the Ukraine, that’s not inflation, that’s just a natural price rise. But we don’t know how much of that price rise is caused by inflation, and how much of it is caused by the real factors on the ground — the actual disruption in oilfield exploration, oilfield drilling, refining, and the transportation of oil from Eastern Europe to other parts of the globe. That’s another cost of inflation — that it can obscure the true cause of the rising price of a good or service.

President Donald Trump signs the $2 trillion coronavirus stimulus relief package, at the White House, on March 27, 2020. Standing, L-R: Treasury Secretary Steven Mnuchin, Senate Majority Leader Mitch McConnell, House Minority Leader Kevin McCarthy, and Vice President Mike Pence. (AP Photo/Evan Vucci)

To what do you attribute the current overall inflation we are experiencing now?

Oh, I have no doubt it is the Federal Reserve’s accommodation, with very loose monetary policy, of the government’s fiscal incontinence over the past two years.

Are you referring particularly to the stimulus bills?

Yes. It started under Trump and continued under Biden. And the Fed has made that fiscal policy much easier for government to carry out, by the Fed, first of all, buying a lot of government debt. When you as a private citizen buy government debt, that doesn’t cause inflation; that simply transfers purchasing power from you to the government. But when the Fed purchases government debt, that does create inflationary pressures, because the Fed simply creates new money that it uses to purchase the Treasury’s bonds. One term that’s used for this is “accommodative monetary policy,” meaning monetary policy accommodating what I believe is utterly irresponsible fiscal policy.

It’s also been referred to as an “easy money” policy.

Right. That’s an even older and more biting term.

The inflation levels we are experiencing now haven’t been seen since the 1970s and early 1980s. On your blog, you’ve unfondly recalled having lived through that period, once writing, “I, alas, am old enough to recall the 1970s.” Can you compare what we’re seeing now to your experiences then?

I was a child and a very young adult in the ’70s, but I do remember the inflation. It was on everyone’s mind. I grew up in a working-class household. And the poorer you are, the more affected you are by inflation. During the ’70s and early ’80s, I remember inflation was running in the low double digits.

And companies would do things that I think we’re seeing companies do now. I remember that in the ’70s, the size of candy bars was reduced. Maybe this was good for Americans’ waistlines, but this is a hidden way that inflation works. Companies worried about a negative reaction from consumers if they raised the nominal price of a candy bar. So they instead shrunk the size of the candy bar a little bit, hoping people would notice that less than they would notice a rise in the nominal price. Either way, you would be paying more for any given amount of the product. But in one case, it’s perhaps less noticeable than the other.

And a smaller candy bar doesn’t show up in the inflation statistics. So when inflation really gets going, it becomes harder to measure, because companies become a lot more creative in figuring out how to hide it.

Federal Reserve Board chairman Paul Volcker listens at a House subcommittee hearing, May 1, 1987. (AP Photo/John Duricka)

At one point in the ’70s, people started walking around with “Whip Inflation Now” buttons, to show they were part of a movement that encouraged reducing consumption as a means of combating inflation.

Yes, that was started by Gerald Ford. It was one of the stupidest things you can imagine, though it’s got a lot of competition.

And I remember Jimmy Carter, who was president when I discovered economics. So by the middle of Jimmy Carter’s presidency, I was already aware of what an economic imbecile he was. Jimmy Carter would blame inflation on consumer greed, that people were consuming too much. Well, my reaction to that is, you can’t spend greed. You can’t walk into a restaurant and ask, “How much greed do you want for that hamburger?” You need dollars. You spend dollars. People can become more greedy, but unless they have more dollars to back their greed, there will be no inflation. So it’s not greed that causes inflation. And let’s face it, the amount of greed, or self-interest, is pretty constant. There’s no reason to think it increases.

The really greedy ones are the government officials who are fiscally irresponsible, and the Federal Reserve officials who greedily accommodate this fiscal irresponsibility for political reasons — it makes their life politically a lot easier. That causes inflation. And then they blame it on Putin. I think Putin is vile for invading the Ukraine. But Putin is not responsible for American inflation. The Federal Reserve is responsible for American inflation. Putin doesn’t sit on the Federal Reserve Board.

America ultimately did get out of that high inflation period of the ’70s and early ’80s, but it took very high interest rates to do that. Is that where we’re headed now?

If we’re going to get out of inflation, we need to put the brakes on the growth of the money supply. And that’s very painful in the short run.

People like to talk about how interest rates will have to be raised, but that diverts attention from where it really belongs. The pain from fighting inflation in a way that’s going to work — as Fed Chairman Paul Volcker fought inflation in the late ’70s and early ’80s — comes not from the high interest rates themselves, but from the reduced growth in the money supply. One consequence of that is higher short-term interest rates, as the banks have less money to lend, because the Fed is less generous in dispensing money to the member banks. But what happens is, the money supply stops growing, but people have these inflationary expectations, so they are reluctant to accept lower wages, or pay raises that are not as generous as the last few pay raises had been — but they need to do that if inflation is going to be kept under control. When the Fed does in fact reduce the growth of the money supply, that ultimately makes it impossible for people to keep spending money at the same rate that they had spent it before.

An alcoholic can put off withdrawal symptoms by taking another drink, but as he keeps drinking he’s going to get sicker and sicker, and eventually die. So he stops drinking — and the immediate impact is horrible withdrawal, and the temptation is to go for another drink. And that’s the case with inflation—when the money supply stops growing, people are denied the drug that they’ve become accustomed to and now they have to get by with lower money-supply-growth. And it takes a while for that realization to set in, to allow them to accept offers of lower wages or lower pay raises.

President Joe Biden signs the $1.9 trillion American Rescue Plan, a coronavirus relief package, March 11, 2021. (AP Photo/Andrew Harnik)

But when the money supply is tightened, shouldn’t the prices drop as well? And if so, shouldn’t people be willing to accept lower wages, since their purchasing power hasn’t actually dropped?

Unfortunately, the prices and wages don’t adjust simultaneously. If the money supply gets cut by 10%, and wages and prices also get cut by 10% immediately, no one’s better off or worse off. But things don’t happen that smoothly. A person sees his own wage, and has learned to expect that the prices he pays for goods and services have been rising at a certain rate, so he doesn’t want to accept a job offer or a pay raise that doesn’t allow him to be able to pay those expected price hikes. And so he demands higher wages, based on expected price hikes, even though those price hikes might in fact not happen.

So you get this distortion in the economy. People don’t know what to do. But if the Federal Reserve is determined enough to wring inflation out of the economy, it can do so now as it did in the early 1980s. People eventually see that the prices are not rising by as much, so that even though my “nominal wage” — how many dollars I am making — hasn’t risen by as much as I had wanted it to, I see that, in fact, the wage that I am getting is in “real” terms — how much purchasing power I have — better than I thought it was.

Paul Volcker changed monetary policy in October of 1979 — I don’t think Jimmy Carter really intended this, but we can applaud Carter for appointing Paul Volcker as chairman of the Fed. Because Volcker — probably against the wishes of Carter, although I don’t know that for a fact — was very determined to wring inflation out of the economy. And we can certainly give applause to Ronald Reagan, who understood that with Volcker keeping the screws pretty tight on the figurative printing press, that was going to make his first couple of years in the White House pretty difficult, because unemployment would rise before people could be convinced that inflation would be wrung out of the system. But Reagan, to his great credit, let Volcker do his thing. And by 1983, 1984, Americans woke up to see that the inflation to which we had become accustomed over the past 10 years finally seemed to be diminishing. Reagan was extremely unpopular in the middle of his first term. When we think back to Reagan now, we think of him as being an enormously popular president. But in late 1982, he was not an enormously popular president, because unemployment was nearly 11 percent. And it wasn’t clear yet that inflation was gone. But within a year or 18 months after that, Reagan’s popularity had gone up, in part because we had defeated the inflation dragon that was slaying us.

Similar to my previous question: Inflation means higher prices — but also higher wages. So aren’t people in fact not losing purchasing power?

Traditionally, wage gains run later than inflation, which is why workers don’t like inflation: The nominal wage stays put longer than do nominal prices. So at first, nominal prices rise, but your wage doesn’t; and now you’re losing purchasing power. It’s only later that the nominal wage rises. 

Federal Reserve Chairman Jerome Powell testifies during a Senate Banking Committee hearing earlier this year.
(Tom Williams, Pool via AP)

Do you have any predictions of where we’ll be, six months, a year, two years from now?

Making specific predictions is a fool’s game, and I’m not in the business of doing that.

Here’s what I see. The Fed will increasingly talk a tough game: “Yeah, we’re going to fight inflation.” But for a long time, the people at the Fed were living in a fantasy world. They kept saying, “It’s transitory, it’s caused by Putin, it’s caused by the pandemic” — anyone but them.

Now they do seem to be at least giving signals that they will take some steps to rein in the growth of the money supply. If they do, in fact, follow through with that, then the inflation will be tempered. How much, I don’t know. And how much the current inflation is going to increase because of the money supply increases in our very recent past, I don’t know. But if the Fed sticks to its word and tackles inflation, then we’ll see at least a reduction in the growth rate of inflation.

But I’ve got to say, I’m not optimistic about the Fed sticking to its word. The Fed is ultimately a political animal. And when politicians complain, generally the Fed listens. Fed Chairman Jerome Powell seems to me to be a very, very political person. He and the other members of the Fed seem to want to be popular.

You mean people like the bartender more than the rehab doctor.

That’s exactly right. The rehab doctor has uncomfortable tools and regimens that make you feel bad. The bartender has all kinds of stuff to keep you drunk.

This is not a prediction, but I hope the Fed becomes more responsible. I’m not terribly optimistic that it will. And if it doesn’t, we are in for more inflation.

The Fed members don’t seem to me to be as interested as they should be in whipping inflation now.

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