“Inflation is always and everywhere ultimately a monetary phenomenon.” Often wrongly attributed to the late Milton Friedman, this comment reflects the conventional view of inflation as a continuous increase in overall prices. It presumes that what economists call the money supply must first grow before prices can move higher. In short, it argues that inflation is merely the symptom and money growth is its cause.
But this view ignores a sturdy pillar of Aristotelian logic – and common sense: a need (more money to pay higher prices) is not a cause. As a matter of historical fact, money growth does not automatically lead to inflation. Just look at the years between 1997 and 2007, when money grew at an astounding pace worldwide. Central banks’ reserves increased fivefold, and that only accounts for “visible” money. Last year, US Treasury Secretary Timothy Geithner estimated that the same amount of money held in “official” coffers could be found in the “shadow” liquidity of hedge funds, structured investment vehicles and other off-balance-sheet instruments.
Let’s recall that in 1998 these instruments were in their infancy. Thus, if Geithner’s estimate is correct, global money increased at least tenfold in a decade. But inflation was subdued during this period. In fact, its polar opposite, deflation, constituted enough of a threat for central banks to open the floodgates of liquidity creation on several occasions.
So, with all that money around, how come inflation was held at bay? There were several factors at work, but two prominent ones were the productivity surge from the information technology revolution – sometimes called “digital deflation” – and the rise of emerging markets as low-cost producers, well-known today as “globalization.”
Indeed, if it weren’t for the enormous money increase, these two factors would have assured deflation, but not the ugly, demand-driven deflation of the Great Depression and Japan’s Lost Decade. Rather, we would have seen a supply-driven version, something that has often occurred throughout history, most recently in the nineteenth century, whenever new technologies made things a lot cheaper.
Are digital deflation and globalization still at work today? According to the latest measurements, productivity gains are slowing now as the IT revolution matures. The promising technologies of the future (nano- and biotechnology, and energy sources like cold fusion, etc.) have not yet left the laboratory and achieved commercial scale. And globalization is no longer as deflationary as it once was. Emerging markets are shifting from low-cost labor suppliers to consumption competitors. They are no longer just lowering global prices through cheap production; now they are also raising prices through increased demand. This shift is already visible on commodity markets.
Moreover, after rescuing the global financial system and their local economies from the economic abyss, governments are set to play a much larger and more central role in economic affairs. Their active involvement raises the risk of a new era of protectionism. Meanwhile, tighter regulation of financial markets appears inevitable. Both of these developments could easily obstruct international capital flows.
So, while money growth alone surely would not lead to serious inflation today, other “horses” stand ready to pull prices higher in the future.
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