This spring I took an Austrian Economics class at the University of Iowa. For our final writing assignment, our instructor gave us a copy of a pamphlet he picked up while visiting the Bank of England.
The pamphlet is an interesting read to say the least. Looking over the pamphlet you will quickly recognize some common themes. Primarily, that the Bank of England is very concerned with controlling inflation. Inflation robs currency holders of their purchasing power. Most people realize this, and want to see inflation kept to a minimum. For this reason, it is in the Bank of England and other central banks’ interest to make it appear as though they are “fighting” inflation. Ironically, central banks are fighting themselves, as they are the sole source of inflation. But this is not what the Bank of England and other central banks want you to think. They insinuate that inflation “just happens”.
What is Inflation?
Unsurprisingly, central banks measure inflation in some misleading ways. Before fully understanding how central banks mislead the public on inflation, it is important to understand exactly what inflation is. For starters, the word is commonly used in two different ways to describe two entirely different things.
- Rising Prices
- Expansion of Money Supply
Until recently (the 1980′s), the dictionary definition of inflation was the latter – expansion of the money supply. This definition makes sense, as inflate literally means to expand. Only recently has the word inflation been defined as “rising prices”. Referring to inflation as rising prices is extremely misleading. Prices don’t expand, they rise, usually as a result of monetary inflation.
What’s the Difference?
This may seem overly analytical to some. Don’t the two definitions refer to the same thing, just from a different perspective? Yes and no, but mostly no. By defining inflation as rising prices, central banks such as the Bank of England can claim they are keeping inflation low, while in actuality inflation is high.
Let’s say the Bank of England were to inflate the money supply by 20%. Using the correct definition of inflation, this equates to a 20% rate of inflation! Now, let’s say the supply of goods also rose 20% in the same period. Under the correct definition of inflation, the rate of inflation is still 20%.
Now let’s use the central bank definition of inflation – rising prices. Using this definition, inflation is 0%. While it may not be immediately apparent, the Central Bank of England robbed the citizens of England of a considerable amount of wealth. Had the Bank of England not inflated the money supply by 20%, the people would be 20% richer because prices would be that much lower. However, since the bank of England devalued their money, the citizens of England can purchase the same number of goods despite producing 20% more.
One of the first things you will learn in any economics class is that things must be considered ceteris paribus (leaving all else constant). In this case, prices are 20% higher than they otherwise would have been had we held the supply of goods constant. By defining inflation as rising prices, we ignore one of the most basic rules of economics. As you can see, using prices to measure inflation is extremely misleading.
It Gets Worse…
If you think that sounds bad, it gets even worse when you look at the methods central banks use to measure prices. One of the most glaring examples of this is core inflation. At first glance, you would assume that core inflation would include the prices of items that we all have to pay for such as food, energy, and housing. Core inflation includes none of these. In actuality, “core” inflation has an inverse relationship to the prices of goods that are actually necessary, core goods. An increase in the price of necessities would actually make “core” inflation appear lower, as there would be less money to spend on non-necessary goods. Since less money is being spent on discretionary goods, the overall price level of these goods would go down, and this would be reflected in the core inflation numbers.
Tip of the Iceberg
And this is just the tip of the iceberg. The price basket of goods is constantly being changed through substitutions, in addition to hedonic adjustments on the goods that remain in the price basket.
In January of 2011, I feasted on a filet mignon at the local Outback Steakhouse for $30. Let’s assume I go back next year, and the price of the same steak is $100! I can’t afford this, so I go with a sirloin steak for $30. The Bank of England and other central banks will often times claim that this is indicative of a 0% rate of inflation. How? Because they substituted sirloin steak for filet mignon in their 2012 inflation numbers. This, as usual, understates inflation.
In January of 2011, I bought a Macbook for $2,000. Unfortunately, a year later, I got carried away while reading an article by Paul Krugman and threw my Macbook out of my apartment window! I go back to the Apple store a year later in search of a comprable replacement, and the price is now $4,000! But because the new Macbook offers twice the hard drive space, central banks such as the Bank of England will often claim that this is not indicative of inflation. This method is slightly more plausible, but as you can see it allows for quite some bias. Given government’s interest in making inflation appear low, it isn’t hard to imagine them manipulating inflation numbers using this technique.
Central Banks Inflate
Although central banks would like us to believe that they are the #1 fighters of inflation, they are in fact the sole source of inflation – expansion of the money supply. With the recent attention on inflation, it is important to know who to blame. Although the government would like us to believe that inflation is the result of greedy speculators and price gougers, central banks have no one to blame but themselves.