"The Keynes Solution" (6) by Paul Davidson - Keynes's New Thinking - Inflation (1)

Image credit.

Continued from here.

With the worry out of the way that a crushing debt burden will cause bankruptcy and the oppression of future generations, we are still left to tackle fears of inflation.

If the government spends inordinate amounts of borrowed money on jump-starting the economy, are we not inviting the threat of inflation? Before we look at the reasoning behind this fear, let us a few steps in clarifying the concept of inflation.

Inflation - and the Inflation of Bad Accounts of Inflation

By way of preface, let me vent some anger over the fact that most discussions of inflation simply bypass the important question why inflation should be regarded a problem at all. The matter is additionally compounded  b y the habit of defining inflation as rise in the general price level: well, what is "general" about the price level? And if "general" means "all", as in "all prices," it is not clear what the problem is supposed to be. If all prices rise to the same extent, say by 10%, well then really nothing much has changed - my bills and my income have risen by the same percentage - so what?

Thus, contrary to philological insinuation, inflation becomes a problem precisely when the price level does not generally rise but unevenly. Inflation is a problem when the price level of my bills rise while the price level of my income stays the same. Thus, inflation is a distributional issue between those gaining from higher prices and those squeezed by them - it is an issue of who gets more, who gets less of the economic pie.

Hyperinflation in Zimbabwe

A popular definition of inflation is "too much money chasing too few goods." It implies a crucial assumption, namely that the amount of money in circulation exceeds the non-inflationary amount of goods. A special case of this is the addition / increase of money to the economy without a corresponding addition / increase of goods. If I give people more money to spend on the goods available in the economy, while the supply of these goods remains unchanged or actually declines, people will have more money to bid up the prices of these goods. This is what happened in hyper-inflationary Zimbabwe, where Mugabe's faithful were instigated to oust the highly productive white farmers, receiving in return for their military feats the farms left abandoned by the dead or fleeing agriculturalists. Mugabe's men were lacking the skills to maintain the former level of productivity in the agricultural sector. The supply of food collapsed relative to the amount of money. The relative increase in money implied inflation. The revolutionary guards may have even received pay rises, yet with their money they were competing for a dramatically falling supply of staples. Money was losing its value. More money than before was needed to pay for a unit of purchase. So, really, hyperinflation in Zimbabwe was induced by an artifice of politics enforcing the political redistribution of ownership from the unskilled but powerful to the skilled but powerless and the attendant destruction of the country's most important economic sector.

That is what we mean by "too much money is chasing too few goods." 

Inflation in a World of Neutral Money - The Classical Case

However, an increase in money could have been used to train and educate the new farmers, provide them with superior technology etc so as to actually improve agricultural productivity beyond previous levels. In this case, the influx of more money into the economy would have increased the supply and quality of goods on offer. There would not have been "too much money chasing too few goods". There would have been no inflationary pressure.

Unfortunately, by another axiom - the axiom of neutral money - classical economic theory assumes that increases in money cannot / do not affect spending and its quality, and thus output and productive employment.

[T]he neutral money axiom asserts as a universal truth that does not have to be proven that any increases in the quantity of money supplied will have absolutely no effect on the amount of goods and services produced (GDP) or on the level of employment.

It follows that if the neutral money presumption is built into the economic model, then if the government "prints" money to spend on the products of industry, inflation is inevitable.

Davidson, P. 65

Hence, Davidson warns:

Blind acceptance of the neutral money assumption prevents a logically consistent analyst from recognizing that if there is significant unemployment and idle capacity, then the additional government deficit spending can and will create profit opportunities and therefore induce business firms to expand output and employment. In this case, the increase in the money supply "printed" to finance additional government spending need not cause inflation.

To be continued here.

PS

Printing Money

Davidson has a passage in which he summarises in masterly brevity what people refer to as government printing money:

How does this printing money process actually work? To the extent that the government wants to spend more than it takes in in tax revenue, the government must sell bonds. If the government cannot find any savers in the private sector of the economy to buy these bonds, it can sell the bonds to the Federal Reserve [the central bank]. In essence, the Fed purchases these government debt instruments by giving the United States Treasury [ministry of finance, in the terminology of non-US countries] a credit on the treasury's account at the Fed. The Treasury can then write checks against this increase in its account at the Fed. Since checks drawn on legitimate bank accounts can settle contractual obligations, the increase in the Treasury's account is the equivalent of the government printing money. But if the government spending of this money goes to encouraging firms to increase output and employment, why should it create inflation?

Ibid., p. 65