March 14, 2016

While the relationship between economic growth and inflation has been much discussed in the economic literature, there is a much more important economic relationship that is far less frequently discussed: the relationship between economic confidence and inflation.

The view of The Money Enigma is that there is, a best, a tenuous relationship between economic growth and inflation. As discussed in a recent post titled “Does Excess Demand Cause Inflation?” the view of The Money Enigma is that high levels of economic growth may lead to higher rates of inflation in the short term, but that, in the long term and all else remaining equal, strong rates of economic growth tend to suppress inflation.

In contrast, the view of The Money Enigma is that, under a fiat money system, there is a strong, inverse relationship between the level of economic confidence and inflation. More specifically, confidence in the long-term economic future of society is the primary driver of the value of fiat money. As confidence in the long-term future of society falls, the value of fiat money issued by that society declines, and prices, as expressed in fiat money terms, rise.

Interestingly, this relationship between confidence and inflation is flipped entirely on its head under a gold standard. Under a gold standard regime, a significant decline in confidence actually leads to a rise in the value of money and a decline in prices.

This stark difference between confidence and the value of money under the two different monetary regimes can help explain why prices fell so dramatically in the early 1930s and why prices are unlikely to fall again in that fashion while we continue to adhere to a fiat money standard.

In the first section of this article, we will begin by discussing the difference between growth and confidence. In the second section, we will challenge the traditional Keynesian view of growth and inflation by examining the relationship between growth, economic confidence and the value of fiat money. In the final section, we will discuss how the relationship between economic confidence and prices changes under a gold standard and why the Great Depression created a perfect storm for deflation.

Growth and Confidence: Same, Same but Different

There is a view that seems to be implicit in the economic community that “growth” and “confidence” are synonymous. While there is clearly a strong relationship between the two concepts, they are not the same.

More importantly, under a fiat money regime, growth and confidence have completely opposite effects on the price level, at least in the short term.

Before we delve into this somewhat complex idea, let’s be clear on how the two terms are defined for the purposes of this article.

Growth is a measure of economic activity in the present time. More specifically, it measures how the level of economic activity has changed from the recent past to the present time.

In contrast, confidence relates to perceptions regarding future economic growth. For the purposes of this article, confidence relates to perceptions regarding long-term economic growth, i.e. economic growth over the next 20-30 years.

While there is clearly some type of relationship between growth and confidence, (one tends to beget the other), the two don’t necessarily move in tandem. More specifically, economic growth tends to fluctuate quite rapidly in relatively short wave patterns, while confidence tends to move in much longer wave patterns. For example, in the 1970s, US economic activity was quite volatile but the overwhelming trend in confidence regarding the long-term future of the United States was down.

This subtle but important distinction can help us understand why some periods of time are marked by high levels of inflation and others by low levels of inflation even when real economic growth, as compared across those periods, is similar.

Growth, Confidence and Inflation: Challenging the Keynesian View

The traditional view taught by many respected macroeconomists is that an excess of aggregate demand relative to aggregate supply causes inflation. Therefore, according to this school of thought, one of the primary roles of policy makers is to ensure that the economy does not overheat, i.e. the economy does not growth too strongly.

Intuitively, this view of inflation is very appealing. After all, it borrows directly from the traditional microeconomic theory that an increase in demand relative to supply leads to a rise in the price of a good.

However, while it may be an intuitively appealing theory regarding inflation, it is also incredibly naïve. Apart from the fact that the empirical relationship between growth and inflation is, at best, tenuous, the simple fact of the matter is that the theoretical underpinnings of this idea are poor.

From an empirical perspective, there is a strong long-term relationship between prices and output that suggests that economic growth tends to subdue inflation. More specifically, the ratio of real output relative to base money as measured over long periods of time correlates strongly with the price level: all else remaining equal, more output equals lower prices. This is the basic long-term application of the quantity theory of money, a theory that does have strong empirical support over the long-term, as opposed to Keynesian output gap theories.

From a theoretical perspective, the key problem with Keynesian aggregate supply and demand analysis is that it ignores half of the picture. More specifically, it completely ignores how economic growth tends to impact long-term economic confidence, which, in turn, impacts the value of money.

As discussed in a recent post “Weak Micro Foundations, Ugly Macro Houses”, the price level is a relative measurement of the market value of the basket of goods in terms of the market value of money. In mathematical terms, the price level is simply a ratio of two values (see below).

If we accept a role for aggregate supply and demand analysis, then the best case that can be argued by the Keynesians is that the intersection of aggregate supply and demand determines the market value of the basket of goods, as illustrated on the left hand side of the diagram below.

It is absolutely fair to say that, in the short term, an increase in aggregate demand, i.e. stronger levels of economic growth, might lead to a rise in the market value of the basket of goods. All else remaining equal, i.e. the value of money remaining the same, this would also lead to a short-term rise in the price level.

The problem with this analysis is that focuses solely on the left hand side of the framework and completely ignores the role of supply and demand for money in the determination of the price level, i.e. it completely ignores the right hand side of the framework.

So, what might happen to the value of money in the scenario above? Does an increase economic activity tend to lead to a rise or fall in the value of money, as measured in absolute terms?

In order to answer these questions, we first need to understand the relationship between economic confidence and the value of fiat money. The view of The Money Enigma is that the value of a fiat currency, as measured in absolute terms, depends critically upon confidence in the long-term economic future of that society. More specifically, fiat money is a long-duration, special-form equity instrument that represents a proportional claim on the future output of society (see “Theory of Money” section).

In practical terms, the value of fiat money rises as people become more optimistic about society’s long-term future. Conversely, the value of fiat money tends to decline sharply when people begin to despair about society’s economic future (think about obvious cases of societal collapse and hyperinflation such as Zimbabwe).

Returning to our example, let’s assume that a pickup in economic growth leads to an uptick in long-term economic confidence. According to the theory above, what would we expect to happen to the value of the fiat money issued by that society? The value of money will rise.

As illustrated on the right hand side of the chart below, an uptick in long-term economic confidence leads, in effect, to an increase in demand for money and a rise in the value of money as measured in absolute terms.

What is the net effect on the price level? In essence, the rise in economic confidence subdues any inflationary impact from the near-term increase in economic activity. Moreover, if the uptick in confidence is strong enough, the rise in the value of money will overwhelm the rise in the value of goods and the price level will fall!

Clearly, this conclusion sits completely at odds with the standard Keynesian view of inflation. Keynesian analysis presents an incomplete view of the relationship between growth and inflation because it dismisses the important impact of confidence on the value of money and doesn’t appreciate the role of the value of money in price level determination. Indeed, Keynesian analysis, doesn’t even recognize the “value of money” as a variable (see “The Value of Money: Is Economics Missing a Variable?”)

In our example above, it is important to note that it is not a pick up in growth per se that leads to an increase in the demand for money. Rather, money is a long duration asset and the demand for money, in this scenario, increases because expectations regarding the long-term (20-30 year) path of the real output rise.

Just as an equity security is a claim on long-term future cash flows, so each unit of the monetary base is a claim on the long-term future output of society. All else remaining equal, as people expect a higher level of long-term future growth, the value of money rises.

Recession, Collapsing Confidence and The Value of Money

The view of The Money Enigma is that just as growth doesn’t equal inflation, recession doesn’t equal deflation.

Economists love to cite the Great Depression as evidence that economic weakness produces deflation. Yet, historical evidence suggests that some of the worst episodes of inflation, i.e. hyperinflation, are associated with economies that are collapsing.

The fact is that the deflationary experience of the Great Depression is simply not relevant to price level determination under our current fiat money regime. Moreover, the fact that economists cite the Great Depression as an example of the link between economic activity and deflation illustrates just how poorly constructed current models of price level determination really are.

In order to illustrate this point, let’s first consider why recession will not automatically lead to a deflationary outcome in fiat money regime and the circumstances in which a recession may actually lead to an accelerating rate of inflation.

In a recession, we can safely say that there is a reduction in aggregate demand. This shifts the aggregate demand curve to the left and the value of the basket of goods falls.

However, this is not the end of the story. Just because the value of the basket of goods has fallen does not necessarily mean that the price level falls. Rather, we need to consider what impact a recession will have on the value of money.

Typically, under a fiat money regime, a recession will tend to dent confidence in the long-term economic future of society. The degree to which confidence is damaged will depend on many factors including the depth and duration of the recession and the level of permanent damage that is done to the banking system and other key industries.

If we assume that the damage to long-term economic confidence is minimal, then the impact on the value of money is likely to be subdued. In this scenario, the value of money may fall slightly or not at all and, given the weakness in aggregate demand, prices are likely to fall (the percentage fall in V_G is greater than the percentage fall in V_M).

However, if the recession seriously erodes confidence in the long-term future of society, then the value of money could decline precipitously. In this scenario, prices will rise. Although the value of goods V_G will fall, a serious decline in confidence will lead to a dramatic fall in the value of money V_M and prices, as expressed in money terms, will rise.

In an extreme circumstance, if confidence collapses, then the value of money also collapses and hyperinflation can result. This outcome is rare because most people tend to treat recessions as temporary events. However, if a recession unmasks or creates serious structural problems, then this scenario can occur.

The Great Depression and Deflation

If this theory is correct and a collapse in economic confidence tends to lead to higher, not lower, prices, then why did prices fall in the Great Depression?

The answer to this is simple. During the early part of the Great Depression, the United States adhered to a gold standard. The reaction of prices to a collapse of confidence is completely different under a gold standard to what it is under a fiat money regime.

If the value of money is tied to the value of gold, then we can replace the market for money on the right hand side of our Goods Money Framework with the market for gold. More specifically, it is the reaction in the value of gold to a fall in confidence that determines the outcome for prices.

As you can see from the diagram above, the Great Depression created a perfect storm for deflation. Not only did the value of goods fall, the value of money rose! In terms of our price level equation, our numerator fell and our denominator rose, leading to a massive drop in the price level.

Economists who argue that a repeat of this scenario is possible in the present day completely ignore the right hand side of our model. Under a gold standard, a drop in economic confidence leads to a rise in the value of gold and, therefore, a rise in the value of money. However, under a fiat money regime, a drop in economic confidence leads to a fall in the value of money. It is almost impossible for prices to collapse if the value of money is falling!

In conclusion, the relationship between confidence and inflation is one of the most poorly understood concepts in economics. While economists love to examine the relationship between growth and inflation, it is confidence, not growth, that is the primary determinant of the value of money and inflation.