Saturday, May 9, 2009

Paul Krugman’s La La Land

Mr. Krugman, like a typical Keynesian, holds onto distorted views. About a year ago he posted the following in his blog to express his belief of malevolent vs. benign inflation. Of course, Keynesians adore price inflation because it is the only way that the real value of wages would decline, which is a required proposition to keep employment high in light of expansionary fiscal and monetary policies they endorse during recessions. That being said, while I don’t fully agree with the likes of Milton Friedman, he was right to point that price inflation is always and everywhere a monetary phenomena. Mr. Krugman cites the following example to promote his view:
"Imagine that there are two entrepreneurs, Harry and Louise, both of whom change prices only at fairly long intervals — say, once a year. Other things equal, Harry want his average price over the next year to be about the same as Louise’s; Louise wants her average price to be about the same as Harry’s. But their price setting takes place on different dates...In this situation, inflation can feed on itself: Harry raises his price above Louise’s, because he expects her to raise her price in the future, and she does the same thing when it’s her turn."

In Mr. Krugman’s example of Harry and Louise, the former can raise prices all he wants—irrespective his motives. What Mr. Krugman fails to note is who will do the bidding and how will the transaction be settled? The customer, of course, but with what money? If an economy (assume produce only one good) has a money stock of, say, $100, and the asking price of the good by Harry is $200, it is impossible for price inflation to occur beyond $100. However, if the central bank increases the money supply to $500, someone will offer to buy at the $200 asking price. Someone will come along, however, and bid $300. Hence an economy experiences price inflation.

The same logic applies to the so call wage-price spiral. That is, higher wages cause price increases. This is a fallacy. Wage demand can increase but if there is no commensurate increase in the money supply, all things being equal, it is impossible prices to increase without demand-side increases.

Keynesians avoid confronting and openly challenging this fact. That is why they rarely mention it in their publications. With this backdrop, it is silly to presume the Federal Reserve balance sheet expansion from $800 billion last August to nearly $2.4 trillion currently will not be inflationary. Any kind of “expectations” management not rooted on fundamental truth will eventually unravel, which will lead to sharp increases in the CPI—although rest assure the government will massage the statistics to deflate them. When that will happen is anyone’s guess? But it’s practically a foregone conclusion that mass inflation (anything above 15-20% annual price increases) is on its way.

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