I am amazed by the volume of verbiage being churned out about oil prices and how this will impact inflation. It shows the level of misunderstanding among economists and financial journalists on this subject.
If you earn R2,000 a month and your fuel bill goes up from R100 to R150 a month, you adjust your spending to accommodate the increase. You do not pass the increase on to your employer, though you may try.
A rising oil price will cause an increase in the price of oil consuming products relative to all other prices. It will not cause a rise in the general price level. The consumer price index (CPI) is assumed to represent a generalised increase in prices when all it really does is measure changes in relative prices. There are endless arguments as to whether the basket of goods chosen fairly reflects the inflation level. But no matter what basket or index we choose, we are still measuring changes in relative prices, not the general price level. This is not to say we should ignore such indices such as the CPI (or indeed the producer price index, which is another relative price index).
Statisticians long ago proved that whenever government increases the supply of money, price inflation rises. The correlation may at times appear loose because the time lag varies, but this is just an apparency. The correlation is indisputable. By misdefining inflation, economists and journalists muddy the subject. I highly recommend an excellent book by Dr Richard Grant called “Real Money” produced by the Free Market Foundation which explains in layman’s terms how exactly inflation is caused. Grant is a former chief economist at the Chamber of Mines and lecturer at Wits, as well as several other universities around the world.
This is not a complex subject. It is very simple. Inflation is not caused by multiple factors such as rising wages, oil and food prices. These are symptoms of inflation. By-products if you like.
Most people understand inflation to mean a vague and generalised increase in prices. It is no accident that the definition of inflation has become so imprecise – it allows government to obfuscate the real cause (government) and then treat the disease by tackling the symptoms rather than the root cause.
As the famous Austrian economist Ludwig von Mises wrote: “What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or fall in commodity prices and wage rates. This innovation is by no means harmless. It plays an important role in fomenting the popular tendencies toward inflationism.”
Von Mises goes on to argue that by misdefining inflation, policy makers are able to shift responsibility for inflation away from themselves.
First of all it must be said that inflation is the greatest economic sin there is. It devalues the assets and labours of every citizen and hits the poor hardest – because the vast bulk of their income is spent on survival, their survival is imperilled. The middle class at least has some cushion against inflation. Inflation has always been recognised as having a single source – when government increases the supply of money, it debases the currency and causes a general rise in prices. Government increases the monetary base (M0, or notes and coins in circulation) through its borrowing programme. It sells bonds, some of which are bought by the Reserve Bank which, by bookkeeping entry, creates new money (this is called monetising debt) to pay for the bonds. Effectively, this is printing money (in centuries past, governments mixed gold with alloys to create more coinage – the effect was the same).
This new money creates a multiplier effect in the banking system, which is able to lend out roughly R9 for every R1 deposited. But there are limits on the banks’ ability to create monetary substitutes (credit) by virtue of the need to hold about 8% of their assets in the form of cash (including the banks’ credit expansion gives us the M3 money supply figure). So the finger points back at government. If government stops inflating M0 money supply, the banks are limited in their ability to create credit.
A rising oil price will be reflected in a rising CPI – purely because it measures prices (i.e. the symptoms of inflation). The way a rise in oil prices will lead to an increase in the general price level is if government inflates the M0 money supply base.
Richard Grant also explains the common misperception about boom and bust economies. At present there is a great fear that the rampant US economy will demonstrate inflationary tendencies. Economists have been puzzled as to how the US economy could chug along for nearly a decade at fabulous growth rates without the usual inflationary symptoms. In other words, the “traditional” boom and bust cycle appears to have been broken. What has happened is that the US Federal Reserve has refrained from inflating the monetary base. An “overheated economy”, according to Grant, “is an episode of unsustainable growth caused by artificial stimulation from monetary inflation.”
Understand this, and we have a far better understanding of how to avoid the mistakes of the past.
Source: Streetwise Investors Newsletter, October 2000
(Real Money is available from the Free Market Foundation 011-884-0270 or fmf@mweb.co.za at R80-00 plus postage)
