Video Transcript: Inflation and Business Cycles | Jonathan Newman

Jeff - Our final speaker this morning is Jonathan Newman. Jonathan is a young  man we're very pleased has become associated with the institute. He is a PhD  student across the street at Auburn University, and perhaps some of his  students are in the room as well. He is also a summer fellow with us last year in  2014, and he's really proven to be a great friend of Mises Institute, and he's  going to speak today at greater length on inflation and business cycles, which  have been alluded to in some of the earlier talks. But he's going to really  hopefully expand our understanding of what inflation is. And when he's done,  prepare your questions. We'll have a brief Q and A among the various speakers. So, with that, Jonathan.  

Jonathan Newman - Thank you, Jeff. I'm a little jealous that both Jeff and Mark  were-they had sort of the nice topics of of where does money come from, how  does the market produce money, and what the world could look like if we had  our way as economists. And so, if Dan and I start foaming at the mouth, it's  because we have the bad topics. We get to talk about war, inflation, and  business cycles. And so, since I'm sort of prone to ramble, I'm going to try to  stick to the script here. But here we go. I want to talk about inflation and  business cycles. The word inflation means different things to different people.  One popular conception of inflation focuses on prices, all prices actually. For  these people, including some economists, inflation means a rise in the general  price level. That is, the goods and services we buy become more expensive.  The other conception of inflation focuses on the money supply. Economists with  this focus think of inflation as an increase in the amount of money in the  economy. We'll see that viewing inflation as a rise in prices can be misleading  and ambiguous, especially compared to viewing inflation as an increase in the  money supply. First of all, prices can rise for many reasons. If the demand for  something increases relative to its supply, or if the supply of something  decreases relative to the demand for it, the price will increase. And the  fundamental reason for this is called diminishing marginal utility. Increasing our  stock of some good means that it will go toward the satisfaction of a lower ranked end. If the next marginal unit goes toward a lower-ranked end, then the  most we are willing to pay for the next unit will be less than the previous unit.  You might be willing to pay $600 for one Apple Watch, which was came out of  the market today, but the most you would be willing to pay for another might be  $100, maybe as a gift for somebody, or so that you could wear two on both of  your wrists. Think of how cool that would look. Even though this sounds pretty  limiting in terms of the reasons prices can rise, these two concepts, supply and  demand, can and do channel all sorts of changes in the market. Preferences  can change. Goods can go in and out of fashion. Accidents can happen that  reduce our supply of a certain good. We can think of new and more efficient  ways of producing goods, services that at one time could only be done with 

human labor can be replaced or complemented with new tools and machines,  and so on. The list of things that affect supply and demand is infinite, depending  on how specific you get. But the important thing to remember is that all of these  sorts of changes are integrated into and channeled through our preferences and ideas, and therefore supply and demand. Secondly, there is really no good way  to measure a general rise in the price level. You may be familiar with indexes  like the Consumer Price Index, which are calculated and compiled based on  survey data and technical mathematical methods, but by their very nature, they  cannot appropriately measure the price level. They cannot do so because these  sorts of indexes are one number. They try to boil the trillions of pieces of data on the on the prices of all goods and services in the economy down to just one  piece of data. Market prices, which are a complicated phenomenon on their own fluctuate not only year to year but month to month, day by day, and even second to second. Also, there is no central repository of price information. Even in one  country, prices emerge in a very scattered, decentralized way, from the halls of  Washington D.C. to the dark back alleys of downtown Chicago, from the lots of  car dealers with neon paint to hand-to-hand to pocket tips for bellhops and  restaurant servers, from fleeting ones and zeros soaring at light speed across  the internet to long-term contracts for land use or film production, one number  couldn't even begin to describe the magnitude and dynamic nature of something like the price level. It would be like driving out west for a camping trip, and going to the remotest location at night to view the stars and a meteor shower, and then a month later, when you return to civilization and cell service, you text your  parents what the view was like and say it was cool. Price index information is  delayed, incomplete, and. By its very nature, incapable of describing the  astronomical picture of market prices, and we haven't even mentioned the well cited issues with surveys, government data, and the more specific issues with  the particular measurements. A third issue with viewing inflation only as a rise in  the price level is that it stops short of explaining the full consequences of  monetary inflation. Many people correctly understand the relationship between  the price level and the money supply. More money means higher prices, and  they also understand that this relationship is bad for the average Joe. Now, Dr.  Salerno, whose first name is Joseph, is not average by any measure, but we  can say that he is-if he is one of the later receivers of new money-he has to pay  higher prices before his own salary increases due to inflation. However, you  define it, in this way, inflation is not harmless. It represents a wealth transfer to  the first users of the new money from the later users of the new money as it  ripples through the economy. Even though most people know and understand  this consequence of increasing the money supply, it stops short of explaining the full consequences of monetary inflation, which will be developed in the second  part of my talk. But to summarize, viewing inflation as a rise in the price level  has at least three main problems. It is ambiguous because almost anything can 

change prices. It is impractical because it can't be appropriately measured, and  it is incomplete because it doesn't tell the whole story of increases in the money  supply, inflation is more appropriately viewed as an increase in the money  supply, and this conception of inflation does not suffer the same problems as the other. Monetary inflation has a simple, well-defined cause, unlike price inflation.  Monetary inflation is measurable because money is its own unit of account and  can be counted up, unlike price inflation, which is not directly measurable,  monetary inflation is also the starting point for the business cycle story, instead  of the stopping point for many like price inflation. Before we can we can discuss  the ups and downs of the business cycle, we have to gain an understanding of  two connected concepts: the interest rate and production. The interest rate is a  price, like any other price, but for present money, it seems weird that buying  money, or it seems weird that you can buy money, but if you just reverse your  perspective of any regular transaction, buying money becomes an obvious and  ubiquitous part of our day-to-day lives. When you buy an Apple Watch or two, if  you want one on both wrists, you exchange money for the device. From Apple's  perspective, though, they are not only selling the watch but buying your money.  The price of your $600 is one Apple Watch. The interest rate is a price for  present money in terms of future money. When you take out a loan, you are  buying present money in exchange for the promise of a future payment. The  relative difference between these two sums is the interest rate, and just like any  other good, the lower the price, the more people will want to buy. At lower  interest rates, more people are willing to borrow. In modern times, we've  outsourced a lot of the lending to banks, which act as financial intermediaries.  Banks use our savings to lend to prospective borrowers, and so the supply of  loanable present money depends on how much people save. Said another way,  it depends on how much people consume, since saving is the opposite of  consumption. The indirectness of borrowing and lending through banks does not complicate things too much. In fact, it makes it easier for us to conceive of the  supply of loans as being made up of savings, entrepreneurs are some of the  primary borrowers of present money. Entrepreneurs buy factors of production  like land, labor, and capital to produce goods and services. They will only  engage in production though if they expect a profit. That is, if their revenues  exceed their costs. If they borrow money to pay for the factors of production,  then the profit would also have to exceed the interest they promise to pay for the borrowed funds. For this reason, the interest rate is a vital piece of information  for entrepreneurs. If interest rates are high, then only highly profitable lines of  production will be undertaken. If interest rates are low, then more lines of  production become profitable. In an unhampered market, interest rates are  determined by supply and demand. If people become more willing to part with  their present money or save, then the supply of loanable funds will increase  relative to demand, and the interest rate will fall. At the lower interest rate, more 

lines of production will become profitable because now entrepreneurs can  borrow more cheaply to purchase factors of production. Since this scenario  started with people becoming more willing to save, it's also clear that the  entrepreneurs will be able to purchase the real resources required for  production. Consumers have shown that they're willing to consume less, so now more resources can be used by producers for production. Let's walk through a  specific example of how this works: Suppose Tim Cook has an idea for how to  produce 1 million Apple watches and expects revenues from his sales to exceed his cost by about 10% He doesn't have the money to pay for the machines and  the laborers and the factories required to produce the watches, so he needs to  borrow. The current interest rate is 15%. Unfortunately for Tim Cook, so we just  hold on to his idea for the time being. However, a couple months later, due to  increased willingness for people to save and invest, the interest rate falls a  whopping 10% down to just 5% Tim Cook reevaluates his plan and his  expectations of profitability, and decides to go for it. He borrows the money  necessary to pay for labor's machines and factories, and starts producing Apple  watches. He sells his product and gets revenue that exceeds his cost by 12%  which was a little more than he was expecting. He pays back his creditors the  amount he promised, 5% which left him with 7% all to himself for taking the risk  and producing something that consumers like. The lower interest rate in this  example encouraged the entrepreneur to produce, and also signaled to the  entrepreneur that resources have been freed up in the economy for use in  production. Now let's see what happens when entrepreneurs get a false signal  from credit markets via monetary inflation. When a central bank decides to  increase the money supply. The new money enters the economy through the  same markets that people borrow and lend. The new money increases the  supply of present money available for lending, which, as we all know, will  decrease the price or the interest rate in this case. To be clear, this time the  lower interest rate does not reflect people's willingness to save or invest, but  only reflects the central banker's intervention. This artificially low interest rate  sends all of the same signals to entrepreneurs and lenders that a normal  interest rate does, but it is not based on people's real preferences. When the  central bank increases the money supply and interest rates fall, it induces more  borrowing and less saving. Entrepreneurs are more than happy to take out the  loans at the lower interest rate, but everybody else is less willing to save at the  lower interest rate. The newly printed money makes up the difference. Less  saving means more consumption, and since the interest rate is so low, they may even borrow to finance even more consumption. Entrepreneurs take their funds  and purchase factors of production, and at the new lower interest rate, the lines  of production they undertake are the ones that weren't as profitable before.  Everybody is happy as they consume, invest, earn higher wages, start new  projects, and enjoy the ride to the top. The high cannot last forever, though. 

Even though spending is climbing on all fronts, no new resources have been  created, just new green slips of paper. The economy has not allocated real  resources away from consumption and towards production; it has just stretched  the existing resources thin. The signals entrepreneurs rely on were falsified and  based on the whims of a few powerful people, not the collective voluntary  interactions of individuals everywhere. The boom peaks and falls into a bust  when some combination of these events unfolds. One, when the increasingly  scarce factors of production become too expensive. Two, when the monetary  spigot gets turned off and so consumption and investment run dry. And three,  when people start to realize the damage that has been done, the bust is  characterized by under and unemployment, falling prices, and a readjustment of  capital through the economy. The bust is painful but necessary and healthy.  Capital and laborers have been misallocated, funds malinvested, and lines of  production that appeared to be profitable are revealed to be unprofitable in  hindsight. The correction happens during the bust. In fact, the bust is the  correction. Resources need to go where they are most highly valued, and the  only system capable of such a daunting and huge task is the unhampered  market economy. In the past and up to today, the necessary correction hasn't  been allowed to run its course before central banks reinflate and restart the  cycle. So it's unfortunate that we have to call the boom bust cycle instead of the  boom bust event. If it were a one-time thing, we might forgive the ones  responsible and say, "Okay, that was an interesting experiment. We didn't really  think it was going to work, but now everybody knows. Sort of like the George  Clooney and Arnold Schwarzenegger Batman movie. Just as the term business  cycle suggests, the artificial booms and the painful bust continue because some  people, especially the government and those connected, stand to benefit at the  expense of others, and because of a general lack of understanding of even the  fundamental mechanisms at work. It's so dreary. So let me try to end on a  positive note. We can avoid the mess. People are getting into and developing  currencies that are not tied to our fractional reserve and central banking system. Newer technologies are being adopted for loans to be processed at rates less  affected by central bank manipulation. Many people are realizing the disastrous  record of central banking and expansionary monetary policy. The same people  are learning the way to real economic growth via real savings and economically  sustainable uses of our resources. Maybe one day we'll look back at the  wrecking ball swings of our current economy the same way we look at the  Batman and Robin, starring George Clean and Arnold Schwarzenegger,  laughing but cringing and shaking our heads. Thank you.