Inflation: A Primer for the Bemused

Since the Covid pandemic began here in the first quarter of 2020, the Australian dollar has been allowed to lose over 13 per cent of its purchasing power. Our younger compatriots are now getting their first taste of real inflation. For years, the captains of monetary policy decreed near-zero interest rates. And now they have driven up interest rates at a speed that misguided borrowers think ferocious.

For most of us, inflation is bad. When the price level rises at an unpredicted pace, wealth is redistributed from people with mainly monetary assets (such as bank accounts and superannuation savings) to people with real assets (land, houses, shares in mines and factories). Wealth is then unjustly redistributed from the poor to the rich and from the young to the old. Low-income earners in particular feel anxious when their costs rise. Inflation also triggers currency devaluations and often import controls, so that consumers have fewer choices and producers have difficulty obtaining new equipment and spare parts to repair their machinery.

This essay appears in October’s Quadrant.
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Inflation allows governments—often the biggest debtors—to repay their loans with money of lesser purchasing power. Moreover, income-tax progression drives many into higher tax brackets. Treasurers become inflation profiteers. This sort of surreptitious “cold socialisation” destroys the citizens’ trust in government. Support for democracy dwindles. When people go hungry, they become radicalised, and moral rectitude wanes. Communities fracture.

Inflation also harms the structure and quality of the capital stock and hence productivity, as people with disposable funds and access to bank loans are unsure whether to risk their time and assets on productive ventures or rather to speculate. The Austrian economist Friedrich Hayek showed that productivity growth and job creation then become weak.

Australians—in particular those under fifty—have up to now gained only a limited understanding of inflation. The exceptions are those who went bankrupt or lost their jobs in the wake of the “Whitlam party”, when a Commonwealth spendathon coincided with a wave of global petrol-price increases and accommodating monetary policy. Other Australians have so far not had the opportunity to learn the lessons of inflation with clarity, as the inflation experience has been of the “frog-on-slow-boil” variety: too slow to expose the real dangers, but persistent enough to do damage. Since the launch of the “Kangaroo Dollar” in 1966, it has on annual average been allowed to lose about 5 per cent of its value. Consequently, the dollar has by now lost 94 per cent of its original purchasing power! Who remembers that a litre of milk cost $0.19 in 1966, a litre of petrol $0.07, and a Holden $2000? One dollar note bought you nearly fifteen litres of petrol. Now it buys about half a litre. This defunct piece of paper has become a collectors’ item.

Does an undramatic but persistent decay, punctuated by rare price-level sprints, matter when the average weekly wage has gone up from $38 in 1966 to $1340 now? It does. Labour productivity would be more robust. Real living standards would have risen faster. And the bounty of a more productive economy would have been shared more justly.

It takes hyperinflation to make the full effects of inflation crystal clear; and then the lessons are not forgotten for generations. I grew up with the family memory of a grandfather, who—when owed several years’ officer salary in the Habsburg army—had consoled his wife with the promise of a good bottle of French champagne once the pay-out came through. When it eventually arrived, the only luxury it bought was a small bag of tomatoes. My wife’s family still tells of a piece of prime land at the edge of Munich, a nest egg which a forebear sold in 1919 for an irresistibly high price. Then the mark dwindled to 4,200,000,000,000 to one US dollar. They felt duped. Such wealth redistribution creates political resentments and instability. It is hard to imagine the rise of a hate-filled, primitive political movement such as Hitler’s Nazis in the 1930s without the hyperinflation of the early 1920s.

I myself had a brief brush with hyperinflation in Bolivia, when the communistic government made me an instant multi-millionaire for a week in the 1980s. I had the privilege to stay in a largely empty, government-owned luxury hotel for the equivalent to US$12, but they insisted on payment in local currency. The room rates were adjusted every day and had to be settled by 11 o’clock every morning. With a few greenbacks in hand, I cruised round the block in search of a black-marketeer. In fear of the La Paz police, I obtained stacks of Boliviano banknotes (abbreviated to BOB), strapped together with rubber bands. Having hurriedly checked whether the parcels contained money and not newspaper clippings, I nervously queued at the hotel’s cashier. Without even looking at my stack of BOBs, he stamped my invoice pagado and nonchalantly tossed the paper bundles into a hessian sack by his feet.

Inflation is defined as the increase in the average of all prices, weighted according to the importance of goods and services to the population. That is the price level. In a living economy, individual prices of course go up and down. What matters is the average. In practice, statisticians select a representative basket of goods and services, typically of what consumers buy—the consumer price index (CPI). When the rate of change from period to period is zero, we enjoy price-level stability. And that should be the policy objective.

Price-level changes result from the interplay between the sometimes temperamental intentions of consumers, investors, governments and foreigners to buy (demand) and a steadily growing supply potential. The latter depends on slow-growing production factors: work and skills, the capital stock and the technical knowledge it incorporates, the natural resources that are tapped, and the freedom with which entrepreneurs can employ these productive resources. Demand management has little effect on the productive potential, but regulatory activism stifles it.

In Australia, there is confusion about how to measure inflation. Some observers remove volatile items from the CPI basket, others the effects of tax and other policy-inflicted changes. We have to learn about overall and core inflation. Sometimes, the authorities argue with the “GDP deflator”, a statistic derived from all transactions that compose the nation’s economic activity. Mrs Average Citizen and shopkeepers are also confronted by differing monthly and quarterly data. Moreover, Australian officialdom aims to create annual inflation of 2 to 3 per cent. Why not 5, 7 or 10 per cent? Fudging the standards may protect those responsible from criticism. Yet, ordinary citizens still find it easiest to plan life and business when there is a zero rate of change. And only in Switzerland can you hear the argument that an inflationary lapse in one year should be compensated by a price-level decrease in the following year to safeguard long-term price-level stability.

Then, there is confusion over how to express the rate of change in the CPI: one quarter to the next, or the quarter against the same quarter a year ago? After a pick-up of inflation, the latter may nurture complacency and allow the monetary authorities to remain asleep at the wheel. This is why the US and Australian practice is to correct the CPI for regular annual price movements (seasonal adjustment) and highlight continual, quarter-to-quarter changes.

Worse still, the instrument of monetary policy is in Australia treated as a multi-purpose tool to attain a diversity of contradictory objectives: a stable price level, fostering employment, even the catch-all “welfare of the people”, and much else. Going by recent utterances of some high-ranking RBA officials, monetary policy now also seems to encompass pushing a net-zero energy policy! With such a lack of focus, monetary policy is ineffectual. The eminent Dutch economist Jan Tinbergen taught us long ago that a policy instrument must be assigned to only one policy objective. It is not a Swiss Army knife. It is to be hoped that the current inflation crisis will lead to a revision of the Reserve Bank Act, which is still imbued with the outdated economic philosophies of the 1950s.

In Australia, we thus suffer from less clarity about inflation and the role of monetary policy than almost anywhere else. That makes for miscommunication, policy fudging and high transaction costs.

This matters immensely. Uniform, immediate information about price-level changes ensures that everybody can remain equally well informed, and less redistribution of income and wealth will occur. Above all, it matters to influencing everybody’s price expectations. As no one expects the price level to double next month, it doesn’t happen. Stable expectations are therefore a great anchor for price-level stability.

How much expectations matter became clear to me when I was working in Malaysia during the first OPEC price rise in the early 1970s. Conservative monetary management had kept Malaysian inflation under control even during the Maoist uprising (the “Emergency”). The OPEC oil-price push of 1971 produced no more than an uptick in the costs of petrol and kerosene for cooking with little impact on the CPI. By contrast, all hell broke loose in Indonesia. Everybody still remembered the Sukarno era’s hyperinflation; anyone with anything to sell immediately saw a signal that inflation was back and upped his sales prices. The monetary authorities had a costly battle to stem an powerful inflation tide.

Since the 1980s, Australians have experienced moderate inflation. This is why the Morrison-era money-and-deficit explosion has so far not triggered more inflation. But the danger now is that an Albanese–Bowen–union cost push amidst still insufficient monetary tightening will cause expectations to edge up. We face the danger of a price-wage-price spiral, which the Reserve Bank is ill-equipped to confront. To stem the tide, a central-bank governor would need gravitas instead of an insecure grin, and the capacity to communicate simple messages which ordinary citizens understand. Waffle about core inflation and finer points of measurement may merely impress journalists and economics undergraduates. The greats among central-bank leaders have always addressed a stability message to ordinary people, whose expectations and decisions to sell and buy play a key role in determining the value of money.

Because he understood the stabilising role of expectations, the Chicago economist Milton Friedman advocated a steady, pre-announced growth of the money supply. Should the plans of consumers, investors or exporters for some reason become exorbitant, thus threatening inflation, market interest rates would rise. This would curb the demand for credit and dissuade producers from pursuing low-profit ventures. At the same time, higher national interest rates would drive up the exchange rate, lowering export demand and making imports cheaper—two powerful effects in an open economy. On the other hand, if buyers of consumer and investment goods were planning very few purchases, market interest rates and exchange rates will in tandem stimulate activity.

This automatic stabilising mechanism is in practice superior to central-bank activism, when central banks vary the official cash rate according to what their models predict—the discretionary approach that Keynes and his acolytes advocated. Yet we know that “economist kings” often destabilise the economy. The RBA’s sorry record over recent years demonstrates how easy it is for discretionary policy to get it repeatedly and painfully wrong. The great advantage of a Friedman-style money-supply rule is that the nation can do without all-knowing economists and modellers. The Chicago economist Henry Simons made this very clear in his 1936 essay on “Rules versus Authorities in Monetary Policy”. People in Martin Place should read his argument.

The longer the inflation genie is not put back in the bottle, the more a price-wage spiral will swing us from a Malaysian expectation scenario towards an Indonesian. Repeated official expressions of hope will not do the trick, because real interest rates are still negative: at the time of writing the cash rate of 4.1 per cent is surpassed by a 5.6 per cent inflation rate. In all textbooks from which I learnt macroeconomics, it is real interest rates and real wages that matter. And a real official cash rate of minus 1.5 per cent just does not signal sufficient resolve to tame the looming inflation juggernaut. The cash rate should surpass the inflation rate by at least two percentage points to put a brake on the pace of inflation. Instead, negative real interest rates have weakened the dollar compared to the US dollar and added inflationary impulses by driving up our import prices and export profits. On top of such monetary timidity, the Commonwealth and the states have budgeted for new spending and debt increases, although people’s living standards are wilting.

Despite US President Joe Biden’s silly remark that “Milton Friedman isn’t running the show any more”, the age-old truth that inflation has always been a monetary phenomenon remains valid. When you blow up the money supply, you produce inflation. When the RBA pumped up the money volume and the Morrison–Frydenberg administration ran budget deficits as if there were no tomorrow, an outburst of inflation became inevitable. And you stop inflation when you stop bloating the money volume. Again, hyperinflations offer a clear lesson. In late 1923, Germany launched a new currency, whose supply was then kept on a short leash. Inflation stopped, and the ailing economy returned to robust health. The same story was repeated in 1948, when the hidden Nazi-era inflation was choked off in one fell swoop with the introduction of the new Deutschmark, followed by monetary discipline. Ignorant Anglo-Saxon economists and journalists termed the ensuing growth record an “economic miracle”—miracles need not be explained, so that there was no need to question the prevalent Keynesian doctrine. In other places, new currencies to replace hyper-inflated ones—deleting two or three zeros—failed because the authorities persisted with easy money and public borrowing. I would advise the new RBA leadership to post some of their bright young economists to Argentina (current inflation rate estimated at 90 to 110 per cent), Zimbabwe (nearly 200 per cent) and Turkey (officially 75 per cent, but in reality much higher). Venezuela, Ethiopia, Haiti, Lebanon and Iran potentially offer even more insightful case material, but life there is too dangerous.

If the growth of the money supply is stopped abruptly and against entrenched expectations, jobs are destroyed and a recession looms. This is why Milton Friedman championed gradual, pre-announced wind-backs of the stock of money. Peter Smith never tires of telling us this fundamental truth in the columns of Quadrant. Some readers have objected to his message with the argument that Australia’s current inflation is in reality caused by the government’s hasty net-zero policies. This is based on a confusion between individual prices and the price level. When a political diktat drives up energy prices, a firm monetary-policy stance forces other prices down, so that the average remains stable. Commentators who depict the powers of the central bank as limited ignore that a steady monetary policy can rely on the tandem of interest- and exchange-rate movements. This is widely ignored by the commentariat—indeed I wonder whether the RBA is properly aware of its own powers and has the courage to use them!

The big misconception about inflation and monetary policy here and in other Anglo-Saxon countries is the Keynesian notion of a trade-off between inflation and unemployment. This has recently led to the outrageous assertion that some people must be pushed into unemployment to support the RBA’s pursuit of moderate inflation, and the erroneous view that “a little bit of inflation” is necessary to promote job creation. Such policy conclusions are derived from the “Phillips Curve”, named after the New Zealand-British economist William Phillips and a paper he wrote in 1958. Yet, history shows that price levels may move independently of the changes in employment and the growth of production. For example, wholesale prices fell during most of Queen Victoria’s reign, while growth proceeded. There was nothing wrong with price-level deflation. A London butler, who received the same number of guineas on coronation day as late in the nineteenth century, benefited from cheaper ales at the pub and falling prices for train tickets home. Lower prices steadily improved his real living standard.

When I was at the Australian National Uni­versity during the Whitlam years, I ridiculed the Phillips Curve notion, only to be told that I occupied the very office that Bill Phillips once occupied. As the term “stagflation” became popular, it was easy to show that the curve, which modellers assumed to run from north-west to south-east, turned around to south-west to north-east, as soon as the Labor government tried to inflate the economy towards higher employment. It was a failure. Central banks cannot print jobs; nor do they produce food, housing or health care. I assumed that the resounding failure of the Whitlam–Cairns administration would completely discredit the Phillips concept. I was wrong: as soon as Wayne Swan sat at the Treasury’s helm in the first Rudd government, the notion that central banks should expand real production was back in fashion. Central bankers, journalists and officious websites now tell us again that inflating the money supply helps business to create jobs.

Let me end with a plea to study economic history and the hyper-inflationary accidents of the past and present. Let us also compare ourselves with relative success stories, such as Switzerland, instead of sheepishly emulating the US, the UK, Canada, New Zealand and the like. When I was in primary school in Switzerland in the late 1940s, my very elementary consumer basket consisted of just one item, a bar of Toblerone chocolate. It cost one Swiss franc. A few years ago in the duty-free shop of Zurich airport, I was delighted to note the price of a Toblerone bar: one Swiss franc!

Wolfgang Kasper, emeritus Professor of Economics at UNSW Canberra, combined an academic career with applied policy work for the German Council of Economic Advisers, as a Harvard Adviser to the Malaysian Treasury, the Reserve Bank of Australia and the Federal Reserve of San Francisco.

A frequent contributor and dear friend of Quadrant, Wolfgang passed away on August 13, 2023, while visiting North Queensland. Jeff Bennett and Greg Lindsay wrote a sympathetic tribute in the Australian Financial Review