The wealth of nations (price inflation and deflation)

The wealth of nations

As time goes on, mankind gets richer. This extra wealth is a result of advances in technology and the effects of cumulative investment. These increase the amount of goods and services that can be produced with the same human labor. Whereas before it may have taken the labor of a thousand people to build a car, today it takes the labor of twenty people. This means instead of cars being only affordable by millionaires, they can now be bought by teenagers using their after-school job savings. This is known as price deflation. The wonderful phenomenon of price deflation—which brings the most exclusive luxuries to the poorest of the poor—is not brought about by:

A. The central bank manipulating interest rates or the treasury printing
money.
B. Wise and benevolent legislation by government.
C. Unions striking for better pay and conditions.

rather it is the result of:

1. Scientific discoveries, such as crop rotation, superphosphate and insecticides.
2. Technological advances, such as the invention of the tractor, combine harvester, mechanized flour mills, and bakeries.
3. The accumulation of capital, such as the clearance of new land and the building of irrigation infrastructure.

Sometimes a sharp reverse of the usual trend occurs (price inflation). It usually lasts only briefly (unless there is a war or socialist government) and then the normal trend of price deflation continues.

The causes of price deflation

Price deflation and economic growth are synonymous. As a nation gets wealthier, the prices of goods decrease compared to how much work people have to do to earn them, and therefore how much of the fixed stock of money they have to hand over to buy them. Price deflation is therefore caused by economic growth.

Technology allows more goods to be produced with less human effort. This means the prices of goods relative to how much labor is required to buy them goes down. This takes place even though the stock of money (the actual notes and coins in circulation) stays exactly the same.

Each factory built, each tract of desert converted to suburbs, each investment made in durable goods, every mile of road laid, every bridge constructed, increases the wealth of a nation and the amount of wealth it can generate by the same effort of its citizens. Thus, each generation benefits from the investments made by the generations that came before them. That is why it is better to be born in the United States or Europe, than in Mexico or Africa.

Keynesian economists wrongly believe that if the government taxes and spends, the effect on economic growth is ‘stimulative.’ They fail to recognize that government does everything inefficiently, and the things socialist governments spend most of the money on are not needed, for example, agricultural subsidies. This makes everyone poorer, because if the money paid to farmers who are not commercially viable had not been confiscated through taxes, it would have stayed in the pockets of the taxpayer and made them richer (able to buy more clothes, holidays, vehicles, childcare, employ more employees, etc.). If they saved the extra money, it could be invested directly in shares or in banks which would lend it out; thus the wealth would be used to create more jobs and more wealth. Meanwhile unviable farmers would be forced to get jobs or produce something for which there is demand. Those activities would add to the economic output of the country and thus to price deflation.

Almost all the elements of good government have a price deflationary effect. For example, the rule of law, sound money, and secure land tenure all greatly encourage commerce, which in turn creates more wealth, resulting in price deflation.

If a country possesses a natural resource and begins to use it, then the wealth extracted will add to national wealth and drive down real prices. This occurs due to:

1. The employment and infrastructure created to service the mining operation;
2. Dividends being paid domestically;
3. Royalties being used to reduce taxes;
4. Royalties being used for infrastructure.

The cause of price inflation

Price inflation and economic recession (negative economic growth) are synonymous. As nations get poorer (due to bad government), the prices of goods increase compared to how much work people have to do to buy them and how much of the fixed stock of money they have to hand over.

But I knew that the main way of reducing consumption was to allow the price mechanism to do its job. The danger, if we did not, was that countries would seek to accommodate higher oil prices by printing money, leading to inflation, in the hope of staving off recession and unemployment. We had seen in Britain that inflation was a cause of unemployment rather than an alternative to it, but not everyone had learned that lesson.

—Margaret Thatcher. The Downing Street Years, 1993.

Price shocks occur when a product used by many people (for example oil) suddenly becomes more costly in real terms. This leads to price increases in all other goods when producers of those other goods factor the increased expense into their own prices.

During the OPEC oil price shock, the price of oil increased so much that most businesses, because they directly or indirectly used oil, were forced to increase their prices. This general rise in prices is called price inflation. It should not be confused with monetary inflation which is caused by printing money. With an oil shock the nation actually has to export more real goods to the Middle East to pay for the same volume of oil. Everyone has to work harder and gets less in return. The following model demonstrates the issues related to a price shock:

There was an island inhabited by fifty villagers. They used clay tablets baked in campfires as currency. Each tablet was bitten by the three village elders while the clay was still soft. This made it impossible to forge the currency, yet no huge amount of labor was needed to create it.

The villagers specialized in the different tasks of fishing, coconut harvesting, hunting, and collecting water from the river. They traded their goods using the clay tablets as money. One day, due to an earthquake, the river suddenly dried up. As a result, the water for the village had to be fetched from a distant spring. The cost of daily water collection rose from being an all-day job for one man to being an all-day job for four men.

This price shock meant that to allow the extra water collecting to be done, three extra men were required. One came from fishing, one from coconut harvesting, and one from hunting. This made the villagers poorer: they collectively had less fish, coconut, and meat. The people were grumpy about this, and the elders felt they had to do something to maintain their position of authority, so they tried government intervention.

1. First they created more clay tablets—equivalent to the daily income of three people. Yet despite distributing these new tablets, the problem stubbornly remained. There was exactly the same reduction in overall wealth (the same amount of uncollected coconuts, fish, and meat). All that happened was the number of clay tablets it took to buy things increased. The villagers noticed that the money received by selling fish, meat and coconuts was now often not worth the effort of producing them (could not be used to obtain other goods of equal effort) so they halted their effort in marginal areas. For example, they ceased travelling to the most distant coconut trees. This led to unemployment. Thus, monetary inflation made the villagers even worse off.
2. The next solution the elders tried was to pass a law banning the four water collectors from charging more for their daily work than one man would. However, the four water collectors needed to eat. They could not live on the food which one man’s income would buy, so they returned to coconut gathering, hunting, and fishing. This meant that no one was gathering water, and the villagers began to die of thirst. The elders responded by rationing water, and long queues formed at the water trough—but as the trough was not getting filled they finally relented and revoked the law. In the meantime, because everyone was dehydrated and had spent so much time in the queue, they were not able to collect as much fish, coconut, and meat. Thus, specific price controls and rationing had made the villagers even worse off.
3. Alarmed at the effects of inflation and realizing that they could not attack the problem by banning increases in the price of water, the elders decreed that no one in the village could raise their prices. It was believed this would keep all prices down, countering the monetary inflation. However, the villagers found that this meant no one could profitably trade anymore, so they all stopped selling their goods and began just collecting for themselves. Thus, general price controls and wages control had made the villagers even worse off.
4. The elders noticed that ever since they began inflating currency, the gatherers of coconuts, fish, and meat would only work half the day and sit around idle in the afternoons. They interviewed the gatherers, who blamed their idleness on people not buying their products. “There is too little demand,” the elders declared. “We must reflate demand, we must stimulate economic activity.” One of them even used a stick to draw a bizarre J-shaped graph in the sand to illustrate this ‘iron truth.’ They decided the best way to proceed was to employ some of the villagers to build a new meeting hall. They reasoned that if they paid the builders generous amounts of clay tablets, the builders would go out and spend the money on increased amounts of coconuts, fish, and meat. This would put the gatherers back to work and prosperity would return. In order to raise the money needed, the elders made new tablets, borrowed tablets, and taxed tablets. However, they were disappointed to find that despite the construction of the new hall, the villagers were now able to afford even less meat, coconut, and fish than ever before. In fact, by this point the villagers had began to die from starvation. This was because the new tablets caused inflation; the borrowed tablets meant the taxes had to go up to pay interest; the taxed tablets meant the villagers, after selling their produce, did not have enough to spare (after paying taxes) to buy other villagers’ produce—so they stopped working (having no incentive to work). Meanwhile, the builders were unavailable to collect food while they were working on the meeting hall, which further reduced output. Thus, economic stimulation had made the villagers even worse off.

We might condemn the villagers as foolish primitives, but it would be unfair to do so. This is because, during the OPEC oil shocks of the 1970s, the United States government tried the exact same solutions with identical results. In fact, as well as trying monetary inflation, price controls on oil, general price controls, rationing, and economic stimulation, they also ran advertisements telling people Don’t be Fuelish in order to encourage lower fuel consumption. To the credit of the villagers in our story, they never ran advertisements telling people not to waste water.

The approach the villagers should have taken would have been to allow the free market to reign. That would have led to the villagers becoming more efficient with their water usage (reducing the number of water collectors from four to three). Then, in order to maintain their lifestyle, the villagers would have:

1. Discovered more efficient ways to fish, using nets instead of spears;
2. Created coconut plantations instead of roaming miles along the shore in search of coconuts;
3. Domesticated pigs instead of hunting them;
4. Moved closer to a fresh water supply.

Thus, eventually prosperity would have returned to the islanders at even higher levels than before. To reach these goals everyone would have worked extremely hard and there would have been no unemployment.

War leads to price inflation because it involves:

1. The destruction of people who otherwise would have lived long productive lives;
2. The destruction of property, which would otherwise have been used to produce more wealth;
3. The diversion of the productive effort away from producing wealth and towards producing weapons and munitions.
4. The diversion of productive effort of those in the armed forces away from producing wealth and towards destruction;
5. Greatly increased involvement of the government in the direction of the economy—with all the vast inefficiencies that entails.

All these factors reduce the wealth being produced and make everyone poorer. This means that even if there is no monetary inflation during the war, the money the people do possess is capable of purchasing far less than before the war.

Increased taxation reduces the money available for investment or consumption. This suppresses investment and reduces the incentive to earn more money. Even if the taxed money is being spent on the taxpayer’s behalf to provide ‘free’ services, the inefficiencies of government mean that much of the captured wealth is lost to the world.

When a previously wealthy country sees a sustained economic decline propelling it towards Third World status, it is because it has adopted socialism, unionism and government intervention. This is what happened to Britain, previously the wealthiest mercantile country in the world. It reached rock bottom in the 1970s when it became the ‘sick man of Europe’, and had to be bailed out by the IMF.

Monetary inflation and credit inflation are different issues

Monetary inflation (caused by printing money) and credit deflation (caused by a collapse in credit) are often confused with price inflation (caused by the nation becoming poorer). These three are all different phenomena, and their remedies are different.