Thursday, July 03, 2008

'Central Banker' surely rhymes with something

Frank Shostak corrects the erroneous thinking that suggests rising commodity prices are causing inflation, and that the world's central bankers are impotent in the face of this inflationary pressure. US Federal Reserve Chairman Ben Bernanke is just another moonbat in thrall to this flawed economic thinking, as evidenced by his claim made to an audience this week that,

Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities.

Is this true? Are price increases in commodities such as oil really responsible for inflation "remaining high"? Of course not, and you don't even need to examine the figures to understand why.

As Shostak explains, Inflation is commonly understood as a rise in the general level of prices -- measured as an 'average' rise in the price of a nominal basket of goods.

We have seen that, according to Bernanke and most economists, it is increases in commodity prices such as oil that are behind the recent strong increases in the prices of goods and services.
If the price of oil goes up, and if people continue to use the same amount of oil as before, people will be forced to allocate more money to oil. If people's money stock remains unchanged, less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come down. Remember: a price is the sum of money paid for a unit of a good. (The term "average" is used here in conceptual form. We are well aware that such an average cannot be computed.)
Note that the overall money spent on goods doesn't change; only the composition of spending has altered, with more on oil and less on other goods. Hence the average price of goods or money per unit of good remains unchanged.

It's so obvious, even a central banker should be able to see it. A rise in the price of one, or several commodities, will certainly have an effect on how people spend their money, and what they spend it on, but it can have no effect at all on overall prices across the board. It can't.

There is however one thing that can have an effect on the general price level, something that touches every single thing that is supplied, demanded and for which a price is charged -- something that touches every single thing in every single market: the rate of increase of the money supply. Explains Shostak,

...the rate of increase in the prices of goods and services in general is going to be constrained by the rate of growth of money supply, all other things being equal, and not by the rate of growth of the price of oil.
It is not possible for increases in the price of oil to set in motion a general increase in the prices of goods and services without corresponding support from the money supply...
The key then for general increases in prices, which is labeled by popular thinking as inflation, is increases in the money supply, e.g., the supply of US dollars.

The quantity of money in the system is responsible for inflation, and far from being impotent to act, this is something Mr Bernanke and his colleagues can very much do something about. After all, it's they who are responsible. The culpability is all their's.

The debunking of this error, by the way, highlights another common and important misunderstanding about inflation. While inflation is commonly understood as a rise in the general level of prices, it can now be seen that a rise in the general level of prices is merely the result of the real inflation:, which is a general increase in the money supply.

Price inflation is merely the symptom for which monetary inflation is the cause. And the cause of monetary inflation is Mr Bernanke himself and his colleagues around the world, and the flawed economic thinking that put them in positions of monetary power.

Given the twin threats of inflation and depression -- with the spectre of stagflation again on the world's horizons -- the world's central banks are facing, according to some commentators, the most challenging economic situation for the last sixty years. Given all that, isn't it a bit of a concern that the thinking of the central bankers themselves on so central a topic is so flawed?

** Read all of Frank Shostak's piece at the MISES BLOG: Commodity Prices and Inflation: What's the Connection?.

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