Austrians often stress that the definition of inflation used by both the State and the economics profession is “incorrect” and that the “general increase in price levels” definition should be replaced by the Austrian “increase in money supply” definition. It is true that the latter is a whole lot more correct in both explaining and describing the problem while pinpointing what is really going on and how these problems could be overcome. However, it is not simply the fact that the generally accepted definition is “wrong” — it is also “evil” in that it includes quite a bit of propaganda for State control of the marketplace and the rest of society.

It should be clear to anyone with some knowledge in how the economy works that all the individuals in it work together like an invisible hand to produce goods and services and that they tend to do so ever more efficiently. This is true even in a regulated market, which is why even monstrous welfare states talk about the importance of and try to “encourage” economic growth. The concept is a bit confusing, though, since the economy doesn’t only grow — “it” strives to get increasingly efficient in the use of resources in order to produce goods and services of [even greater] value to consumers. Such increased efficiency is generally achieved by entrepreneurs, be they capital owners or labor workers, and innovators finding new ingenious ways of using the resources available.

In such a market the natural tendency is for prices to fall — anything else would be incomprehensible. Even in the world of neo-classical economics this is a fact despite the endless calculations on fixed cost functions and production technologies. Competition spurs cost-cutting and efficiency-increasing measures for the actors to gain advantages in the market through satisfying consumers’ wants by offering better products at lower cost. So how could prices ever increase in such a setting?

Yet the definition used for inflation is the general increase in prices. Of course, even those trained in mainstream neo-classical economics should realize such a phenomenon is a symptom of something being wrong. But what is commonly overlooked or not understood (or at least not mentioned) is that inflation is not something going wrong as shown in price increases — it is wrong because prices don’t fall. In other words, if inflation is taken as only the price increase the statistic necessarily and systematically overlooks the natural price fall that is also a part of inflation.

If prices in the market would naturally fall by 5% in a specific year but we instead experience a 5% increase in prices, the real “price increase inflation” isn’t the experienced 5% increase compared to the level of prices the previous year but the new level compared to what the level would have been, i.e. 105%/95% = 10.5%. In this simple example the official inflation statistic would only take into account less than half of the real price increase inflation.

The inflation statistic of 5% in the example doesn’t take into account that the market is never static; it simply compares the price level of one year with the price level of another year as if nothing has happened: the cost and production functions are the same (i.e., competition has no effect), the money supply is exogenous or unimportant (i.e., printing more money has no effect), and time has a “reverse” effect (it would obviously be better to always sell goods at a later time while producing as early as possible since all prices go up — the best thing you can do is horde and “never” sell).

It is true that such a world as the one implied by the inflation statistic is very neo-classical in that it is so oversimplified that it doesn’t make sense at all (but allows for taking nice derivatives to optimize abstract functions). It is also true that it is literally impossible to tell how much prices would have fallen, which means the inflation statistic is nowhere close to the real inflation rate and also that it is impossible to even guess how wrong it is.

For obvious reasons the State benefits quite a lot from using this definition of inflation. After all, it covers up most of the effects of its tampering with the market. But why in the world would anyone doing economic research use such a statistic that is so totally flawed? One possible answer to this question is that the economics profession (generally speaking) is not about economic truths, but aim to serve the State through providing research on how it can “optimize” its policies to best take advantage of the market processes. If this is the case, then the economics profession overall should know little about how the market really works — and what would cause it to fail.

 

Adapted from Inflation Research as Propaganda, originally published at LewRockwell.com