More About Inflation

Inflation that affects the entire economy originates with government action. Price increases that arise from temporary imbalances between supply and demand in specific product markets are not examples of general inflation.

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If bad weather or other factors reduce the yield of food crops like wheat or corn, the lowered supply (or anticipation of reduced supply) will cause prices to rise in world markets. Higher prices will deter some buyers, reducing demand until prices stabilize at some higher level. Higher prices will induce farmers to increase acreage planted for the next crop season, thereby moving anticipated supplies back up toward normal demand levels, until prices stabilize at reduced levels. Summertime increase in the price of gasoline similarly reflects seasonal imbalances between supply and demand. Such price fluctuations in response to supply and demand in specific sectors of the economy are not evidence of general inflation. Quadrupling the price per barrel of oil after 1973, however, was a different matter. Throughout the 1950s and 60s, middle eastern crude oil, quoted on world markets and paid for in dollars, averaged between $5 and $10 per barrel. President Johnson's Great Society entitlements programs in the mid-1960s sharply increased Federal deficit spending, which the Federal Reserve accommodated with increases in the money supply, in amounts exceeding real production growth in private enterprises. As was true in recent years, with fiat money readily available through the banking system, our imports began to exceed exports. Dollar balances held abroad rose to levels exceeding our gold reserves. Foreign central banks holding mounting dollar reserves were concerned about the falling purchasing power of the dollar (i.e., about the beginning of general inflation). We were still on an international gold standard, and foreign central banks could demand gold for their dollar holdings at the official exchange rate. The Banque de France began exchanging its accumulating reserves of dollars for gold held by the U.S. Treasury. Our monetary gold supply dwindled and the dollar continued depreciating. President Nixon in 1971 implicitly acknowledged our nation's bankruptcy by abandoning the Bretton Woods monetary stabilization agreement, taking the nation off the international gold standard. No longer would the Treasury exchange gold for dollars held by foreign central banks. At the same time, Nixon imposed wage and price controls in a futile effort to head off rising inflation. In his remaining years in office and during President Carter's hapless administration, with the dollar no longer anchored to any standard of value, inflation soared. During this time, petroleum entered the picture in a decisive way. The Organization of Petroleum Exporting Countries (OPEC) instituted an oil embargo in response to American support for Israel during the 1973 Arab-Israeli war. The embargo lasted until 1974. Equally important for OPEC nations was their recognition that, at price levels than prevailing for oil, they were being robbed by inflation. Since that time the western world has become more efficient in its use of energy sources. But in the 1970s, OPEC's four-fold increase in the price of petroleum, the most widely used energy source, hammered our economy. Responding to the crisis, the President's Council of Economic Advisors and the Fed, both beguiled by Keynesian economic nostrums, continued tinkering with interest rates and pumping out excessive amounts of fiat money. Contrary to confident expectations (cf. Paul Krugman today), the Keynesian house of cards collapsed. The United States entered the punishing epoch of stagflation: simultaneous double digit inflation and very high unemployment. In Keynesian theory such conditions were held to be impossible. Government had only to increase deficit spending. Gullible consumers, responding like Pavlov's dogs, would automatically increase consumption expenditures, unemployment would drop, and the nation would return to perpetual economic boom conditions. Instead, conditions worsened. The advent of Fed chairman Paul Volcker at the end of the 1970s finally halted the economic catastrophe, ending double-digit inflation. Volcker abandoned Keynesian orthodoxy, recognizing that inflation could not be halted by tinkering with interest rates. Inflation, he said, was the product of an excessive money supply. Stopping general inflation then was economically and socially painful, as it will be today if politicians can muster the will to reduce deficit spending and curtail the Fed's ability to create fiat money. Volcker drained excess liquidity from the banking system. Interest rates skyrocketed and the nation plunged into the the 1982-83 recession. But his actions, coupled with president Reagan's tax cuts, stabilized the dollar and put the nation onto one of its longest and greatest periods of production increases and job creation. THE CRITICAL POINT TO RECOGNIZE is that our horrendous stagflation of the 1970s was not caused by wage increase pressures or by OPEC's oil price increases. First came big increases in Federal deficit spending and the Fed's accommodative inflation of the money supply. Our recent housing bubble and meltdown of the banking system were created by similar government action. For an extensive exposition of the processes of inflation and its effects, read Austrian Economics vs. Bernanke's Economics.