Inflationary Expectations
By Christopher Lingle
A triumph of education in the 20th century was that economists convincingly argued that inflation was caused by excessive monetary creation, usually at the behest of politicians.
A scientific and popular consensus formed that recognized inflation to be the result of actions of elected or appointed officials who controlled the money supply. As such, citizens were less likely to blame greedy grocers or omnivorous oilmen or testy trade unionists for higher prices.
Since then, hyperinflation that plagued much of Latin America became a rarity while ``garden variety'' inflation seemed to be tamed in industrialized countries.
Of course, this all changed quite recently with Zimbabwe concocting rates of inflation that would shame the efforts of the Weimar Republic in destroying the value of the Reichbank's mark.
And now it is painfully clear that rumors of the death of ordinary inflation in the rest of the world were largely exaggerated.
Recent, unfortunate lapses at keeping inflation at bay are yet again the result of rapacious rulers and incompetent central bankers. It seems that lessons that were so long in learning have been lost so quickly.
One result of the consensus about the cause of inflation was that central banks became less susceptible to populist and political exhortations to debase money. In earlier days, politicians were able to feign innocence and shift the blame for inflation onto others.
But central bankers are playing similar games by trying to shift the blame when price indexes began rising. And they redefined prices indexes to understate the effect of their policies.
Another ploy is for central bankers to claim that expectations of consumers or producers are a driving force in an economy, a view held by many mainstream economists.
As such, ``positive'' thinking or ``good'' news can prevent bad expectations from developing that might cause a fall in economic activity. And if individuals are driven by psychological processes and susceptible to wild swings, insights into these processes can lead to better public policy choices.
An aspect of this issue relates to inflationary expectations that are currently receiving extensive media coverage. Central bankers and policymakers are making considerable noises about how important it is to dampen expectations of future price rises.
For his part, Ben Bernanke as chairman of the U.S. Federal Reserve is on public record suggesting that he believes rising prices indices are driven by inflationary expectations. But this explanation of how and why consumer or producer prices rise lacks merit and should be abandoned.
It is as though prudent policymakers can make timely interventions to control mass psychology to keep an economy on a stable path. Presumably, convincing individuals that everything is fine can change economic fundamentals and reverse conditions that presage a decline.
As such, many economists try to accentuate the positive when discussing the state of the economy so as not to upset the applecart, including when a recession is looming. By conjuring up greater confidence, economic activity can be more robust.
And if pigs could fly!
Expectations are neither necessary nor sufficient for increasing price levels. As it is, economic theory and historical evidence indicate that an inflated money supply is the primary and fundamental cause of rising prices.
If the central bank does not inflate the money supply, there can be no general acceleration in prices regardless of so-called inflationary expectations.
Even if a sudden and sharp increase in the price of energy or food induced people to expect higher inflation, an unchanged money stock will not allow it to happen!
An inconvenient truth is that managing perceptions and expectations cannot alter economic fundamentals. It turns out that actual impacts will be felt even when people are unaware of policy changes.
In all events, attempts to guide expectations are undermined by extensive economic illiteracy since most people do not understand the impact of policy changes.
Assigning so much importance to inflationary expectations involves utilizing a psychological explanation even though it contradicts basic economics.
It matters not that highly-respected economists indulge in such fantasies. Indeed, perhaps 95 percent of professional economists think along similar lines. But that does not mean that they are right.
One current worry is that workers (or other input providers) will negotiate larger wage settlements, driving up costs and prompting producers to seek higher prices. Were this fable true, workers would never be displaced by higher wages.
And companies would never go out of business since docile consumers would meekly continue to buy as much as ever even though prices are higher.
Depicting expectations as a determinant of inflation (or prompt an economic downturn) violates fundamental notions of economics. For example, wage payments are ultimately limited by labor demand that economists describe as marginal revenue product whereby selling prices constrain wage settlements.
Firms trying to earn profits will not pay wages exceeding the additional gains in revenue arising from the additional production from hiring another unit of labor. And they will not pass less if competition for competent workers leads to wage rates being bid up to that level.
In all events, the truth is that inflationary expectations are not a primary cause of anything. It should be understood that such expectations are caused by loose monetary and credit policy.
If central banks make credit artificially cheap and inflate the money supply, they provide investors with financial means to throw money at highly-speculative ventures.
In turn, this leads to speculative excesses and rapid growth of asset values since investors tend miscalculated their future costs. Without the monetary expansion or new bank-financed credit, other transactions throughout the rest of economy must fall in an offsetting manner.
It turns out that expectations expressed by consumers or businesses, per se, are only important if their anticipations correspond to economic realities in the future.
Rising expectations do not cause ``inflation" and have no lasting impact on economic conditions unless accompanied by an excessively-expanding rate of growth of the money supply.
Christopher Lingle is research scholar at the Centre for Civil Society in New Delhi and visiting professor of economics at Universidad Francisco Marroquin in Guatemala. He can be reached at CLingle@ufm.edu.