Inflation as Mud in the Economic Water
AIER has a long history of warning against the dangers of inflation (see, for instance, founder E.C. Harwood’s 1976 book, “The Money Mirage: Luring Businessmen, Savers, and Investors to their Economic Deaths”). Most observers of the economy are likely familiar with the most well-known of these critiques, such as the transfer of wealth from savers to the government in the form of seigniorage and the potential for out-of-control hyperinflation. But one everyday consequence of even low inflation is that it complicates the economic decision of firms and households, pulling the economy away from efficient outcomes.
In his 1963 monetary history, “What Has the Government Done to Our Money?,” Murray Rothbard argues that inflation “distorts that keystone of our economy: business calculation. Since prices do not all change uniformly and at the same speed, it becomes very difficult for business to separate the lasting from the transitional, and gauge truly the demands of consumers or the cost of their operations.” In other words, a business might see an increase in the price of a certain good and be uncertain whether it stems from inflation or a specific increase in demand for that good. Inflation adds yet another layer of uncertainty and obfuscation to the already complex set of calculations that underlie a businessperson’s decisions.
It is easy to lose sight of this argument, as Rothbard spends only two paragraphs on it amid numerous other critiques of inflationary monetary systems, but the idea is still discussed today. In a paper published last year, William Gavin uses the same idea to argue against unexpected changes to inflation targets: “People must tax their memories and powers of calculation to compare the value of goods at different periods of time. Difficulties with accurate price comparisons lead to economic inefficiencies that reduce economic output or, at least, the social value of output.”
While very similar to Rothbard’s argument, Gavin’s is also informed by ideas from behavioral economics. While traditional economic models in the past half century often assume agents with unlimited powers of calculation, behavioral economists emphasize “bounded rationality,” which attempts to account for both cognitive limitations and the time it takes to make economic decisions. Instead of fully calculating optimal economic decisions, consumers and businesses often use heuristics, or rules of thumb that make decisions tractable and not unduly burdensome on time and energy. However, when inflation happens in the real world, small and scattered price changes may be missed by heuristics. The average household does not have the time or ability to monitor the size and source of price changes for everything purchased. The household members may not be aware they are spending more on a given item, and this lack of awareness distorts decisions.
These effects may appear individually small but can grow with more inflation over time and pile up on each other in our complex modern economy. While it is highly difficult to measure the magnitude of these effects, inflation’s potential to complicate and obscure economic decisions should be included in our monetary debate.
Max Gulker
Max Gulker is a former Senior Research Fellow at the American Institute for Economic Research. He is currently a Senior Fellow with the Reason Foundation. At AIER his research focused on two main areas: policy and technology. On the policy side, Gulker looked at how issues like poverty and access to education can be addressed with voluntary, decentralized approaches that don’t interfere with free markets. On technology, Gulker was interested in emerging fields like blockchain and cryptocurrencies, competitive issues raised by tech giants such as Facebook and Google, and the sharing economy.
Gulker frequently appears at conferences, on podcasts, and on television. Gulker holds a PhD in economics from Stanford University and a BA in economics from the University of Michigan. Prior to AIER, Max spent time in the private sector, consulting with large technology and financial firms on antitrust and other litigation. Follow @maxg_econ.
