Sunday, June 29, 2008

Inflation not purely a monetary phenomenon

I'm puzzled. Milton Friedman said, "Inflation is always and everywhere a monetary phenomenon," yet when I apply this to the UK it doesn't work.

I looked at the Bank of England's figures for M4 from end 1963 to end 2007, and by my calculation the monetary base has increased by a factor of about 240; yet prices have increased only 15 times in the same period. (*)

Currently (and time permitting) I'm also working through David Hackett Fischer's "The Great Wave". In his concluding chapter, he lists seven different causal explanations of inflation, and none of them quite fits the observed facts, not even monetarism. For example, in the sixteenth century, European prices began to rise some time before the imports of gold and silver from the New World could have made a difference.

His idea is that inflation-waves are "autogenous" (don't academics love this kind of label?), by which he means that people make decisions based on current circumstances and their personal predictions for the future, and that helps shape the next set of circumstances. It's like watching a football game unfold, each player adjusting his movements according to his perception of the others.

Fischer thinks that one important factor in the price-wave of the Middle Ages was a trend towards marrying earlier and having more children, which put pressure on natural resources at the same time as altering the ratio of working adults to dependant children. Perhaps this has modern echoes in the growing longevity and reducing mortality rate in the developing world, plus the increasing numbers of dependant elderly in most places.

At any rate, inflation in the West is likely to become less susceptible to control by adjusting the interest rate. What will the Monetary Policy Committee do then?

Perhaps it might help if we established some control over the actual amounts pumped into the economy by the banks (and other creditors). I can dimly remember the news in the 60s, about limits on how much you could borrow to buy fridges, washing machines etc - apparently a minimum deposit was a requirement of the Hire Purchase Act 1964.

However (it seems), Japanese manufacturers found ways to get round this and offer (in effect) 100% loans, and then came the pandemic of credit cards, starting with "your flexible friend" Access (1972). Telegram Sam the drug dealer is always friendly, at first.
(*) Unless, of course, the discrepancy is accounted for by (a) the need for the monetary base to expand each year to cover interest on loans already made, and (b) much extra money being locked-up in real estate - an awful lot of building and rebuilding took place as the postwar economy recovered.


Ryan said...

It doesn't necessarily follow that an expansion in money supply (M4) leads to an increase in inflation. What would happen if the population had doubled over the same period? All the extra M4 money supply would be absorbed by the new citizens (in fact they would generate this M4 supply by requiring the money to build a new home, and then spend the rest of their days creating real wealth to pay for it all). Any expansion in real productivity needs an expansion in money supply to justify it - otherwise the economy would actually be constrained by the availability of cash. This is what happens in a gold based economy - the gold itself starts to take on greater power than real wealth - you end up with people living in appaling conditions as they take part in the Klondike gold-rush and such-like, chasing after something you can't build houses with and can't eat.

Bear in mind also that the measure of inflation is extraordinarily narrow. M4 money supply hasn't resulted in much CPI inflation - but property prices have ballooned over the same period, and not just domestic property.


Yes, I was being a bit slow there, Ryan. You're obviously right about house prices, and inflation effects being uneven, and inflation measures being very arbitrary.

Yet even after all that, prices up 15-fold in 44 years - I make that 6.35% compound p.a.

Ryan said...

A lot of the growth in M4 has gone into buying Chinese patio heaters - i.e. massive growth in UK debt has not resulted in increased inflation because it has been spent on new products we never used to buy before. Thus the inflation indicator can no longer be used as an indicator of excessive increase in money supply - it is broken.