The spectre of inflation now scares most around the world. Predictions by some economists and central bankers that it would be temporary are proving wrong. Money is losing value at an accelerated pace. Even economies where the authorities are engineering a recession are heading into a sustained inflation wave. Stagflation—inflation while growth stalls—is back. Relearning the lessons of history is now urgent to clear up muddled and short-termist thinking about the causes of inflation, and to set up durable remedies. The fundamental lesson is that the price level goes up when central banks print excessive volumes of new money and allow commercial banks to extend easy credit, so that excessive money chases an only slowly growing supply of goods and services. Inflation is thus a monetary phenomenon.
This insight goes back at least to the ‘gold inflation’ of the 16th and 17th centuries, when Spanish galleons brought huge amounts of gold and silver to Europe, bloating money volumes. Governments could spend big, including on wars, and the churches and the rich could enjoy a more sumptuous lifestyle. But production grew only slowly or was even hampered by wars. The rise in the cost of living caused poor workers, and in particular young workers, to see their real incomes and life opportunities dwindle, while owners of land and capital enjoyed asset price inflation, at least for a time. Within 200 years Spain, which had been the richest and most powerful country in Europe, was a basket case.
Scholars in the Renaissance-era School of Salamanca analysed this inflation plague. They discovered and refined what has since become known as the ‘quantity theory of money’. It gained great influence in the wake of the stagflation of the 1970s, after eminent economist of the University of Chicago, Milton Friedman, published empirical and theoretical studies that gave monetarism modern substance. Its main conclusion is that inflation inevitably follows money printing and deficit finance, though with a variable time lag of about two years. As Friedman put it in his 1992 book Money Mischief: Episodes in Monetary History, this correlation “plays the same foundation-stone role in monetary theory that Einstein’s E = mc2 does in physics”.
US historian David Hackett Fischer showed in a magisterial study that major price waves affect entire generations. Documenting inflation waves over the past 1,000 years in Western nations, he invariably identified dire social, cultural, and political consequences: inflation unjustly redistributes incomes and wealth; it triggers social fragmentation, substance abuse, rising crime, and violence. Governments suffer fiscal stresses and some go bankrupt. Political disorder leads to revolutions and alienation from the established, peace-supporting order. Inflation-weakened States lose military contests. Cultural anxieties darken the mood of a generation and lead to lower birth rates and often also higher death rates.
Fischer’s work, The Great Wave: Price Revolutions and the Rhythm of History (Oxford University Press, 1996), established that throughout history it is the poor who pay the most for monetary irresponsibility with their penury, sweat, tears, and blood.
ASPECTS OF INFLATION
It is important to distinguish between the proximate (immediate and visible) causes of inflation—say a rise in the price of gas or living-cost increases due to disrupted food supplies—and the underlying cause, namely an atmosphere of lax money. The price level is stable when the weighted average of the individual prices of a basket of goods remains constant. When some prices rise (as is normal), other prices must fall. For example, when a hasty, policy-driven transition to alternative sources of energy pushes up the cost of electricity, inflation control demands this must be compensated by price reductions elsewhere. For example, a tightening of monetary policy could appreciate the currency and thereby lower import prices.
In a living economy, individual prices affect expectations of profit and loss. As long as the overall price level is stable, the price mechanism is an incredibly effective coordinator of disparate human activities. Price increases stimulate supply and ration demand, whereas price drops discourage some more costly sources of supply and stimulate demand for a product. But with inflation and—worse still—fluctuating rates of inflation, people cannot be so sure what the change of a specific price means.
Does this reflect underlying market conditions or past, present, and future inflation? The ‘radio traffic of price signals’ is, so to speak, overlaid by more and more static. Capital gets misallocated in speculative ventures and efficiency is lost. Marxists have given the automatic price-profit mechanism a bad name. They forget that the word ‘profit’ derives from the Latin proficere, achieving an improvement.
The poor pay the most for monetary irresponsibility.
Unfortunately, many business executives have over recent decades downgraded profit signals and replaced them with triple bottom lines, confusingly adding environmental, social and governance (ESG) targets. Banks engage in virtue signalling by trying to enforce such non-profit objectives that detract from the main measure of business success, namely profit which is in the interest of the owners of the firms. The actions of banks like Westpac refusing to finance coal mines at a time when the world is crying out for more supply—as signalled by record high prices—is an example of such arrogant folly. Economic coordination becomes disoriented and economies stagnate unnecessarily.
This is the proverbial Economics 101 lesson, yet left-leaning American economics Nobel laureate Joseph Stiglitz and the Australia Institute recently lobbied Australia’s new Treasurer Dr Jim Chalmers to introduce a ‘super-profits tax’ to neutralise steep price increases for some goods and deny producers of extremely scarce goods, such as gas, the profit stimulus to expand supply. They reflect the anti-market prejudices of anti-capitalism critics who sit in tax-financed welfare oases. Chalmers had the good sense to reject the advice.
It is also basic economics that, in factor markets—for example, markets for labour, skills, and capital—the price that matters is the real price (the nominal price adjusted for expected inflation). Accelerated inflation of the sort we now experience lowers real wages and real interest rates. With predicted inflation of seven to eight per cent per annum, the official RBA cash rate is now around a negative six per cent per annum in real terms. Even with official rates being notched up in mini steps, savers and borrowers face negative real rates; an unhealthy condition for long-term prosperity because it drives asset-priced inflation and encourages non-productive speculations using borrowed money.
One often hears that zero inflation is incompatible with high employment and hinders the wide sharing of productivity gains. Historic experience contradicts this. During the late 19th and early 20th centuries, wholesale prices in most Western countries fell over extended timespans, yet production and general incomes boomed. For example, a London butler, who received roughly the same nominal salary at the beginning of Queen Victoria’s reign as at the end, enjoyed substantial improvements in his real living standard as he could now afford many more pints of ale and more trips to his home village.
1970S MONETARIST REFORMS
In reaction to Stagflation Mark 1 during the 1970s ‘oil crisis’, central banks of most developed nations were given responsibility for safeguarding the value of money and made independent to insulate them from inherently opportunistic politicians and the associated risk of voter backlash. To this end, they got powers to set official cash rates and influence the capacity of commercial banks to extend credit. In addition, the central banks obtained the complementary and very powerful instrument of freely moving foreign-exchange prices, which is the prices of imports expressed in domestic currency and the costs of exports to foreign buyers. If, for example, the economy overheats, higher interest rates and tighter credit conditions lower the cost of imports and restrain demand from foreign buyers through an appreciating exchange rate. Inflation may thus be hit by two simultaneous punches! Central bank governors therefore have no excuses for not fulfilling the assigned task. Their powers are not only an opportunity to safeguard the value of money, they come with the obligation to do so. Nor do central bankers have the excuse that other central banks tolerate inflation. Defending the value of national money—whatever it takes—can, of course, not be had without pain. That is, after all, why central banks are given autonomy.
In Australia, the monetary constitution was recast only partially and belatedly. The Australian dollar was floated only in 1983, but the Hawke government omitted to make price-level stability the Reserve Bank’s exclusive policy objective. Instead, a multiplicity of objectives—prices, employment, the growth of production, and even the catch-all, feel-good task of pursuing the “greatest advantage of the people of Australia”—were retained in the 1959 Reserve Bank Act… as if monetary policy were a Swiss Army knife to be used for diverse and contradictory tasks. These intellectual residues of 1950s paleo-Keynesianism gave the money managers wide sway to forget that they were the ultimate arbiters of our cost of living.
Ever since Wayne Swan became Treasurer in the first Rudd government in 2007, the commitment to protecting the $A’s purchasing power has weakened. Behind this was the Keynesian view that there is a trade-off between (mild) inflation and high employment. The idea derived from statistical work by Kiwi-British economist William Phillips, who showed that—in the 1950s—a curve relating inflation to unemployment ran from NW to SE. Alas, as soon as policymakers relied on this so-called Phillips curve, it rotated from SW to NE: we got higher inflation with higher unemployment. Although this experience should have discredited the concept, it again became a persistent element in the policy tool kit when builders of quantitative economic models, who lacked a deeper understanding of economic history and human psychology, became the main advisors on economic policy.
Central banks have lost their mojo for fighting inflation.
Expectations play an important role in keeping the price level constant. The only reason why prices will not go up tenfold by tomorrow is that no one expects this. However, the anchor of stable expectations can get lost. That is the case in episodes of hyper-inflation, for example between 1919 and 1921 in defeated Germany, Austria and Hungary, a trauma that gave rise to the calamities of the 1930s and World War II, and now in Zimbabwe and Sri Lanka. Yet, the quick defeat of hyperinflation, for example in Germany in the 1920s (and again after the monetary reform of 1948), was proof that an end to money printing will promptly stop the monetary disease.
In the early 1980s, inflation in major economies was brought under control. In the US, for example, Paul Volcker let the US funds rate rise to a peak of 20 per cent per annum in 1981. It was in consideration of this short-term pain for long-term gain that then president Ronald Reagan famously said, “If not us, who? If not now, when?” Thereafter, low inflation became an anchor against fast future price rises. Sluggish expectations at the beginning of the 2020s explain why the impact of the accelerated inflation of the money volume was delayed for a time, which created illusions among economists and econometricians ignorant of history.
Savvy central bankers used to put a lot of effort into cultivating stable expectations. They focus on one price index (say, the consumer price index) and promise to keep it constant. Sadly, we now see less clever central bankers argue with a confusing multiplicity of indexes (headline inflation, underlying inflation, year-on-year, one-quarter to the next, seasonally adjusted etc). The signals are muddled further by official inflation standards that deviate from zero. Why two to three per cent per annum, and not five to seven per cent next year? Why not define next year’s metre as 103cm? Befuddled standards provide confusing signals to all those who are busy negotiating millions of market-price changes every day.
Over the past decade, most central banks have failed abysmally. At least since the global financial crisis of 2007-08, they have lost their mojo for fighting inflation. They became handmaidens of vote-buying politicians, forgetting their obligation to the citizens; namely to keep money scarce so it can properly fulfil its essential functions as a means of payment, a store of value, and a standard of account. The COVID pandemic removed the last holds on spendthrift governments. Public deficits are no longer financed by recourse to private savers who buy government bonds, but the printing press. ‘Quantitative easing’ became the policy norm, inducing many individuals and corporations to take up loans they would be unable to repay in normal times. This fuelled asset-price inflation, with one effect being a rapid rise in the costs of Australian homes, making it much harder for the next generation to become homeowners. But neither lax money nor reckless government spending are good means to create jobs and stimulate the growth of production.
The Australian Government has burdened future taxpayers with a debt of a trillion dollars, as detailed in a recent IPA report by Daniel Wild and Dr Kevin You, ‘Australia’s Debt Disaster: Estimating Interest Repayments On Federal Government Debt By 2030’. The resultant huge interest payments will have to take precedence over building schools, hospitals, dams, and enhancing our military defence capability. Never has so much money swamped the world economy. Even if quantitative easing is now by-and-large shelved, Stagflation Mark II is more daunting than the situation 50 years ago. Readers, who are not terrified yet, should turn to Professor Fischer’s above-mentioned work on the frightful consequences of inflation.
Monetary policy targets the total demand for goods and services. Lax monetary policy causes interest rates to fall and borrowing to increase with a consequential surge in the demand for goods and services. Tighter monetary policy does the reverse. But of course economists have two hands: on the one hand there is demand, and on the other supply. In assessing monetary demand management, one has to acknowledge that the task of defending price-level stability is made a lot easier when the apparatus of supplying goods and services is responsive to price-profit signals, that is when supply is ‘elastic’, to use the economist’s phrase. A competitive, open economy populated by entrepreneurial workers, competitive capital owners, and innovators can avoid inflation much more easily than a regulated, rigid one.
Overcoming the looming stagflation of the 2020s and early 2030s must therefore become a whole-of-government task. Alas, the conditions on the supply side look grim in most developed countries, and particularly in Australia. The juggernaut of the regulatory state has progressed over past generations despite intermittent attempts to free up private decisions on what and how to produce and supply. The recent COVID disruptions and the impacts of the Russian aggression against Ukraine have added short-term bottlenecks and inflexibilities. But the consequences of these short-term factors are greatly exaggerated by opportunistic politicians who shy away from real reforms or are committed to new inflationary interventions. If macroeconomic policymakers ignore the massive microeconomic challenges on the supply side, the inflation wave will last a very long time and massively hurt the economically weak.
In Australia, one can point to countless rigidities placing undue burdens on monetary policy. What measures could expand the productive potential of the nation, lowering prices and expanding supply? Some of these opportunities are long term, but others promise quick rewards. A good example is housing policy. Financial assistance to new home buyers has added demand pressure and increased prices. What is required is a boost to the supply side: State and local governments should release more land; regulations relating to building permits could be relaxed; and building applications streamlined and processed much more expediently.
Assistance for new home buyers has increased prices.
As a stream of IPA Research has shown, rising red and green tape more generally adds to business costs and chokes supply. New mining ventures, for example, have become marathons in which proposals amounting to metre-high piles of paperwork have to be submitted. Proposals meet with vexatious legal challenges and have to be resubmitted multiple times with responses and variations. Farmers must endure endless certification training and form-filling to send their products to market. The regulatory environment is even tougher for businesses directly engaged with the general public. Compliance with unduly onerous health and safety laws impose ever more significant costs. Often, regulations address circumstances that are rarely experienced, making them excessively costly relative to the benefit provided.
Australian labour markets are riddled with regulations that constrain productivity improvements. Central bargaining results in awards that are ‘one size fits all’, when in fact the operations of businesses and the lives of individual workers are so diverse that the flexibility of individual employment contracts is required to allow for diverse paths of growth. Setting minimum wages likewise constrains the ability of some businesses to grow and for some workers to get into the job market, especially when said minimum wages are some of the highest in the world.
At present, international conflicts contribute to stagflation dangers from steeply rising energy prices. But much of the energy emergency can be counted as an own goal. Restrictions or complete prohibitions on fracking have constrained the potential of domestic gas production. Complex, convoluted approval processes have delayed and even thwarted new gas exploration and project development. In Victoria it was for a time banned altogether, and remains severely restricted. Government-funded lobby groups exploit legal processes to stall or halt supply expansions. We are now warned of a 10 per cent gas shortage in 2023, which would affect electricity supply and might force some gas users to close down. The automatic gut reaction of interventionist bureaucrats is to prohibit some profitable export contracts. While a government-mandated gas trigger against exports may ease supply in the domestic market, the long-term supply-side effect will be to make gas production more risky and less profitable.
The market for electricity has been made dysfunctional by multiple and contradictory interventions. The injuries caused by CO2 emission targets to the supply potential have been addressed by band aid after band aid. The full costs of trying to influence the global climate are becoming evident only now, which has lead to sudden reversals in plans to curb reliance on coal and gas in many countries. Even some European Green politicians now see electoral advantage in suspending zero-emission policies, especially in Germany where power is already rationed so that coal and gas can be stockpiled for the winter. People now also start to realise that all the pain experienced has been without an impact on the global climate. When Friedrich Hayek wrote of a ‘fatal conceit’ in The Fatal Conceit: The Errors of Socialism (University of Chicago Press, 1988), he could not have found a more telling example.
The complete removal of all subsidies that give artificial profitability to renewable energy investments would be a start to rejuvenating energy supply. It would also help to diminish fiscal deficits. Allowing undistorted competition between energy suppliers without layers of regulatory imposts should be next. That needs to be on the basis of reliable, deliverable power, and not on assumptions that the sun shines, the wind blows, and future technologies will be more efficient. Removing restrictions on nuclear power and high-efficiency, low-emission coal-fired power stations, including CO2 emission bans, would promote aggregate supply. The policy of adding ever more subsidised ‘renewables’ to electricity generation will only make it less reliable and drive up costs.
Free markets would resolve the controversies about the relative cost and reliability of renewables, fossil fuels, and nuclear electricity in quiet, non-political ways. Without an expansion of supply and a concomitant increase in the flexibility of the nation’s productive apparatus, inflation will persist and growth will at best remain weak. Concerted action to ease the regulatory burdens on Australian producers is the way to ease the pain of necessary monetary contraction and to realise the growth potential of our resource-rich nation. This would make the task of monetary policy a lot easier.
‘WORLD’S BEST CENTRAL BANK’
The Reserve Bank of Australia, though not alone in grossly misjudging the inflation caused by the unprecedented flood of money, was particularly obtuse to the time-tested insights of monetary theory. As late as August 2021, it prognosticated low inflation and promised ‘highly accommodative monetary conditions’ for years to come. It is therefore not surprising that the new Labor government initiated a review of the Bank, hoping to obtain advice how to create ‘the world’s best central bank’. To that end, Parliament should rewrite the outdated Reserve Bank Act and assign the independent RBA only one policy objective: absolute price-level stability, whatever it takes. The Treasurer should then appoint persons with good knowledge of monetary theory to the posts of Governor and Deputy, persons with leadership qualities, the courage to assert themselves, and the vision and persuasiveness to earn the trust of a busy public—not pale technocrats and administrative types who share US President Biden’s ridiculous, much-derided opinion that “Milton Friedman isn’t running the show anymore”.
Parliament should rewrite the outdated Reserve Bank Act.
On the RBA Board, a balance should be established between appointees who see the world through the eyes of borrowers (businesspeople, mortgagees, government agents) and members with the mindset of savers (private households, superannuation funds). The Treasurer should make it clear to the RBA leadership that they will be penalised for inflation. The Governor’s high salary must come with a malus—a negative bonus—of 10 or 20 per cent of her or his salary of nearly $A1 million; and three-year-long failure would end the tenure of their leadership. The Treasurer can impose these stern rules because central banks nowadays have absolute power over the growth of money supply.
The RBA’s job would be very hard, but not impossible if the government failed to remove many of the present and prospective obstacles to productive flexibility. The cost of living could then be kept stable only at great cost to some. The Fraser government (1975-1983) attempted to cure Stagflation Mark I with ‘masochistic monetary restraints’, while leaving market supply-constraining market interventions and protectionism intact, an experiment better not repeated. Similar, probably harsher pain in the late 2020s would not be the RBA’s fault, but that of the Commonwealth and the State governments.
Many other nations experienced an easier time than Australia in the 1970s and early 1980s because supply-side reforms accompanied strict monetary restraint. For example, Paul Volcker’s successful attack on entrenched inflation coincided with the justly celebrated Reagan liberalisation of production and trade, which paved the way for an era of stability and prosperity.
These proposals may look politically unrealistic as of 2022, but five years of excruciating price-wage-price spirals and disruptive distribution warfare will make such a package of monetary and microeconomic reforms politically acceptable. Timely, concerted action in this well-endowed and democratic country can lay the basis for a new golden era of prosperity, confidence, and optimism. After all, learning the lessons of history and then applying them resolutely is the test of greatness.