In a recent post, I discussed sound money insofar as it enables macroeconomic stability. I emphasized one argument made by George Selgin and others concerning the information content of prices over time. Every economist fortunate enough to have a grandpa has had to explain at one time or another that, even though one might have purchased a candy bar for a nickel seventy-five years ago, candy bars are much cheaper today, in real terms.
The information content of prices over time is clearly lacking in such a world. However, some might maintain (as a commenter on George’s post did) that such losses are small and do not generate much macroeconomic instability, if any at all. If that’s the case, the argument goes, we should just stabilize prices and be done with it. In what follows, I will draw on another argument made by George in Less than Zero and the more concise version included in my comment with Alex Salter to demonstrate the problem with such a view.
Consider what would be required to stabilize the price level in the face of productivity growth. Suppose, for example, that a cost-saving technology is adopted by an automobile manufacturer. Initially, the automobile manufacturer is the only person in the economy who knows of this new cost-saving technology. The automobile manufacturer offers his car at a lower price than his competitors to gain market share and, in doing so, conveys that there has been technological growth and a corresponding change in relative scarcity to everyone else. Nothing new here that isn’t in Hayek’s Use of Knowledge in Society.
Now, reflect on what happens to the price level. Suppose initially the price level were P1, the weighted average of the prices of cars, boats, apples, etc. Since the price of cars has fallen, and no other prices have changed, the aggregate price level falls to some level P2 < P1. Stabilizing the level of prices would require raising the prices of all goods (cars, boats, apples, etc.) to some new level P3 where the relative price ratios underlying P3 is identical to those of P2 but the level of prices in P3 is equal to P1. In terms of conveying information about the relative scarcity of goods and services in the present period, P2 and P3 are equally good. The difference is that, to obtain P3, we have to change a lot more prices.
If it is costly to adjust prices—which seems reasonable to assume—we should surely prefer P2 to P3. They both covey the relevant information but the latter comes with a higher cost. Again: good money is one that expands to offset increases in money demand and contracts to offset decreases in money demand but does not change to account for changes in productivity (except insofar as the productivity brings about changes in money demand). Changes in the price level driven by productivity provide valuable information over time. Trying to offset such changes requires a costly adjustment of prices with no offsetting benefit in terms of the degree to which prices convey information about relative scarcity.