The Inflation Fallacy and central banking debates in the US

Among my favorite contemporary academic economists is N. Gregory Mankiw. I have always found his academic writings very lucid and to the point. I was once again reminded of this today, when I stumbled over some debates about abolishing the Federal Reserve System. Opponents of central banking, mostly self-proclaimed followers of the “Austrian school”, view central banks as monopoly powers that undermine free markets and are inherently inflationary – implying a government-supported devaluation of the population’s wealth. In the United States, these opponents are having golden days, as they can blame the Fed for having not only caused the financial crisis, but also for engaging in irresponsible quantitative easing that will inflate the US economy to pieces.

Well, one of Mankiw’s principles in his successful undergraduate textbook Principles of Economics is that “Prices rise when the government prints too much money”, so it is not really disputed that creating too much money is inflationary. Think about Zimbabwe. (It is, however, open for debate whether it is true when nominal interest rates are at, or close to, zero, but leave that aside for now.) And sure, governments and central banks can and do make policy mistakes and may in many circumstances be tempted to be more inflationary than is good (think Zimbabwe again). This was realized by Kydland and Prescott in 1977, but the United States is hardly Zimbabwe when it comes to central banking. What are then the fears in the minds of those wanting to get rid of the Fed?

Ron Paul, republican congressman from Texas, has recently embarked on a crusade against the very existence of the Fed under the heading “Sound Money”. On the site RonPaul.com the concept is explained by alluding to a story akin to Milton Friedman’s helicopter drop of money. In the Ron Paul story, by contrast, it is “money elves” that overnight bring money to people. The story then goes along as usual, namely that as demand increases, prices go up. But the mechanisms at force in mainstream economic models suddenly stop short: Workers’ wages suffer from perfect and permanent nominal rigidities. So, the fable about the money elves ends by people facing lower real wages. So people are worse off, except those lucky few who are interconnected with the creators of the money elves (i.e., some evil companies and bad financial institutions who are friends with the Fed).

This is not how the usual Friedman helicopter-drop-of-money story ends. (Not even Carl Barks’ 1950 Donald Duck cartoon A Financial Fable ended on such a depressing note.) It ends by all prices in the economy eventually being increased proportionally by the increase in the money stock. And hence also the price on labor, i.e., wages. Nothing real has changed. The fable of the money elves suffers from “The Inflation Fallacy” described by Mankiw in his Principles book:

“If you ask the typical person why inflation is bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars (…)

Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus inflation does not in itself reduce people’s real purchasing power.”

Simple. Money is neutral in the long run. So an inconsistent story about money elves seems to be a weak case for drastic monetary reform. Of course, more detailed arguments are put forth by others, but they appear more like ideological arguments based on principles of individual freedom, completely free markets, anti-government intervention, inter alia. Not healthy economic theory.

But hey, some would ask, isn’t Mankiw just part of The System that helps suppressing the “right” economic theories like those of the Austrian School (discarded in 1998 by Paul Krugman as “being as worthy of serious study as the phlogiston theory of fire“)? Maybe so, but could it be that the little space such theories take up in standard textbooks is actually a sign of their failure of surviving the free market forces of economic thoughts?