Frank Shostak – October 10, 2019
Some commentators are of the view that whenever the economy gains strength it should be the role of the Federal Reserve to step in at some stage and introduce a tighter stance in order to prevent a general increase in the prices of goods getting out of control. However why should economic growth be positively associated with a general increase in the prices of goods and services?
When we talk about economic growth, what we mean by this is an increase in the production of goods and services that people require to support their life and wellbeing. Since the price of a good is the amount of dollars paid per unit of this good, then obviously for a given amount of money an increase in economic growth (i.e., an increase in the amount of goods and services), must lead to a decline and not to an increase in the prices of goods and services in general. (We now have more goods for an unchanged amount of dollars).
Hence, it makes sense that there should be an inverse correlation between changes in the prices of goods and services and changes in the production of real wealth as depicted by the growth rate of industrial production, all other things being equal.
Why then there is positive statistical correlation between the yearly growth rate of the core consumer price index (CPI adjusted for food and energy) and the lagged yearly growth rate in industrial production (see chart below)?
Why should more wealth, which raises people’s living standards, also generate negative symptoms — such as a general increase in the prices of goods and services?
Why Economic Growth Cannot Be Measured
As it stands, real economic growth cannot be ascertained as such since it is not possible to add together different goods. For example, it is not possible to add potatoes to tomatoes in order to obtain a meaningful total that is required to calculate real economic growth.
Economic data that is employed to calculate economic growth has nothing to do with real economic growth as such. It is monetary turnover, which is deflated by a dubious price deflator. This means that what is labeled as economic growth is in fact the growth rate of a distorted monetary turnover data, which is erroneously called total real production.
According to mainstream thinking the stronger the monetary pumping is, the stronger the pace of spending is going to be and consequently the stronger the monetary income and the so-called real economy is going to be. In this framework, more money means more spending and this leads to stronger economic growth.
Observe that what we have here is an increase in the monetary turnover on account of monetary pumping, which is presented as a strengthening in real economic growth, and an increase in general prices also on account of the monetary pumping. Hence, it is not surprising that we observe positive association between the so-called economic growth and price inflation.
Again, what we have here is a situation wherein monetary pumping is positively associated with a strengthening of price inflation and economic activity (i.e., a strengthening in the monetary turnover). The charts below depict this vividly (see charts).
But to properly establish the valid relation between the production of goods and the prices of goods, we must rely on an accurate definition of what drives prices, and not on statistical correlations. This will show the relation between changes in the production of goods and changes in prices must be inverse, all other things being equal.
But a proper understanding of how wealth is created shows a fall in prices is the manifestation of real wealth expansion. It means that every holder of dollars can now have access to more real wealth (i.e., goods). Hence, a fall in prices whilst real wealth is rising is great news.
Note that most commentators are likely to suggest that we are ignoring the facts of reality here to establish the association between economic growth and price inflation by just paying attention to the essence of prices while ignoring statistical correlations.
But correlations without good theory are not terribly useful. Unfortunately, the world is [a] very complex place, and it is not easy to grasp what is going on by means of direct observation. This is more rigorous thinking and theory is necessary.
The purpose of a theory is to establish the essence of the subject of investigation. In our case, the essence of the price is the amount of money paid per unit of a good. This is valid for the prices of all goods and services. Again, a price of a good is always the amount of money paid for the good.
If the amount of money remains the same, but the number of goods have increased, then prices are going to go down, all else being equal.
The fact that prices and economic growth may go up together does not prove economic growth leads to price inflation. It only shows there are other factors at play.
Logically, it does not make much sense that genuine economic growth can lead to general price inflation. The positive statistical association between economic growth and price inflation is not because of an expansion in real wealth but comes in response to the expansion in money supply.
Originally published at Mises.org.
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