Tuesday, 10 January 2006

Too-fast growth is bad. Right?

It's probably unfair to pick on Jordan when he's still not returned from holiday, but hey, I never said I was fair. "I'm not fair." OK? Right then, on to the post: As an aside before leaving for his holidays, Jordan mentioned that "the economy is slowing down after five years of, perhaps, too-fast growth." Now that's a pretty common view, and one heard from many voices -- at least one of them emanating from the Reserve Bank. 'Too-fast' growth in productivity causes rapidly rising prices, and has to be stamped down into mediocre growth, or even no growth at all. 'Too-fast' growth is A Bad Thing.

Better no growth at all, says this view, than 'too-fast' growth.

But can it be true? In what sense can economic growth be 'too fast'? How can increased wealth production possibly be A Bad Thing? For RBNZ Governor Alan Bollocks, growth is 'too fast' when it somehow challenges his 0-3% inflation band -- and everyone knows that high economic growth causes inflation, don't they?

Well, they'd be wrong. The 'Philips Curve' and the Keynesian analysis behind it are what supports the 'Economic Growth Causes Inflation' Myth -- and they'd both be wrong.
This curve, now viewed by some as an economic law, was constructed decades ago and asserted that there was a "trade off" between unemployment and inflation -- that high inflation provided lower unemployment and low inflation created higher unemployment. But almost as soon as the Philips Curve became economic orthodoxy, actual experience contradicted it. Inflation coincided with increasing unemployment in the 70's, while falling inflation coincided with reduced unemployment during key periods of the 80's and 90's.

Keep the following in mind: Inflation is a reduction in the purchasing power of a unit of currency. As governments control currencies, they create inflation. Inflation can be observed by tracking changes in currencies relative to precious metals and other currencies. Over time, a currency's decline manifests itself in higher prices for industrial and consumer goods. An economy reacts poorly to the uncertainty and confusion of inflation, which hurts growth, and an economy responds favorably to the stability of low inflation, encouraging economic growth. In either case, an economy reacts to inflation and government currency policy; it cannot create it.
There you go then, and not so difficult to understand. Pity then that we have a Reserve Bank Act predicated upon a Myth. The Myth is made more so by a misunderstanding of what inflation really is; to remind you from above: "Inflation is a reduction in the purchasing power of a unit of currency," brought about by an increase in the money supply. The former is a result of the latter. Prices can rise for many reasons quite apart from monetary inflation; when a price rise is due to supply and demand reasons, it's called a price signal -- stepping on price signals distorts the market. It really is A Bad Thing.

It is only when prices rise due to monetary inflation that it is a problem. To classical economists, inflation is the undue increase in the supply of money above the rates that can be supported by savings. The RBNZ's 'basket' of goods and services by which they measure price inflation is not an accurate reflection of underlying monetary inflation -- a measure of the money supply is.
As long as consumer prices (as measured by the CPI) are not rising, or are rising only modestly, it is assumed that there is no inflation, or only very little inflation. Dr. George Reisman suggests that this is "..akin to saying that so long as someone shows no visible signs of illness, he has no illness - that his illness begins only when its symptoms become unmistakable." He goes on to say that "inflation does not come into existence when prices start rising noticeably, any more than heart disease or cancer come into existence when a person finally has a heart attack or experiences the acute symptoms of cancer. On the contrary, these diseases are already well advanced before their obvious symptoms appear."
'Too-fast' growth causes an increase in wealth, not an increase in inflation. What causes inflation is printing money, and only the central banks of government can do that.

Linked Article: The "Economic Growth Causes Inflation" Myth


  1. CPI has problems - as any system of measurement would - but have you seen this fascinating tool?: the CPI inflation calculator from RBNZ. Hours of fun!

    You say that they "print money". Although I am not an economist I note that it is more nefarious than that. What they call M3 or the total credit that the central banks (and the other banks via them) create can run well ahead of the actual printed money. I think the Eurozone had an 8% increase in M3, even though inflation was below 2%. Now that is supposedly good management as the increase was not inflationary and unlike NZ they do not have outrageously high interest rates (which of course they pretend is not part of inflation). But you go too deep into this stuff and it's Matrix territory.

  2. The reason they believe that too fast growth is a bad thing is because they observe boom bust cycles and fail to realise the booms are sectoral (tech in the late 90s, cars in the 20s) and not economy wide.

    Growth in particular sectors can be a bad thing - when it is the prolonged growth funded by easy money credit policies. You'd think it would be obvious that the growth of particular sectors can't outstrip the rest of the economy indefinitely as those sectors would asymptotically approach becoming the entire economy. While initial fast growth of new industries is fine (and necessary for there to be new industries, given the small starting base), people get caught up in new-economy hysteria time and again throughout history.


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