Economic Myths #6 - Price Stability

[First published on Free Life]

One of the mandates that our economic lords and masters have arrogated for themselves is that of maintaining so-called price stability, a constant purchasing power of the monetary unit in our wallets.

At first blush, price stability sounds rather appealing – not only does it “bless” us with the apparition of certainty but are we not also “protected” by the potential of higher prices in the future? If so we can assure ourselves that our cost of living will be sustained and manageable, relieved of the horror that the essential consumables may some day be out of our reach.

Unfortunately this ambition is not only disastrous for a complex economy but is also antithetical to the nature of human action in the first place. The whole purpose of economising action is to attempt to achieve more for less – to direct the scarce resources available to their most highly valued ends and to gain the highest possible outputs with the lowest possible inputs. In short, economic progress means that we are gradually able to attain more and more for the same amount of labour; or, to put it another way, we could attain the same quantity of goods for a lower amount of labour. Any consistent attempt to stabilise the prices in the economy would not only target the goods that we buy with our money but also the goods that we sell – and that, for most of us, means our labour! But if we cannot sell our labour for any more and if we cannot buy our wares for any less then it means that we will simply be locked into a repetitive cycle of working, buying, consuming and working again for the same prices for the whole of our lives with no improvement in the standard of living whatsoever. Instead of economic progress bringing goods at cheaper prices to the lowest earners, the only way to improve one’s wellbeing in such a world would be to become a higher earner – i.e. by working harder or longer.

Of course, real price stability never does and never can work in this way for it is impossible for a centralised authority to monitor and regulate all the many millions of individual prices and exchanges that occur every day in the economy. Instead, such authorities monitor and target the mythical pseudo-concept of the general “price level”, usually concocted by taking a selective index of goods – an index that can be altered conveniently in order to paint the data in the fashion desired. Individual prices within the index, however, may still fluctuate relative to each other even though the absolute price average may appear constant. This fact may not mean a great deal to the bureaucrat but is of great importance to the individuals who wish to purchase those particular goods. Furthermore, because of the belief that a dose of price inflation is good for a growing economy, “stability” usually tends to be defined as including some measure of price inflation such as the Bank of England’s 2% inflation target. We are apparently “stable” when the government is robbing your pay packet of some of its purchasing power, it seems.

Such a policy is not restricted to existing as a mere moderate tempering of an otherwise healthy and growing economy. Rather, it can have disastrous and deleterious effects upon the entire system. The outcome of a genuinely progressing economy with sound capital investment should be a gradual, secular price deflation where goods and services become cheaper over time. If central banks attempt to counter this in order to achieve stability it must lower interest rates and print more money in order to devalue the monetary unit relative to goods in order to prevent prices from falling. However such an act is what induces the ill-fated business cycle; prices may appear stable but the relative prices of capital goods will begin to rise and those of consumption goods to fall as the new money gets sucked into ultimately unsustainable investment projects.

This is precisely what happened in the 1920s when a high degree of productivity was countered by a voluminous expansion of credit that masked price rises, giving the illusion of price stability and suckering promoters of the scheme (such as Irving Fisher) into believing that they were living in a new era of permanent prosperity. The same was also true of the run up to the tech boom collapse at the turn of the century and the housing market collapse of 2008; these had been preceded by a period of low interest rates and apparently low price inflation – alleged hallmarks of an successful economy – that camouflaged the underlying distortions, leaving mainstream economists scratching their heads in confusion as to what went wrong.

Far from creating certainty and consistency, achieving “price stability” is one of the very worst horrors of a centralised, bureaucratically managed economy. Free market prices mean something - they result from the underlying supply and demand relationships so that goods are rationed to their most productive uses. Interfering in that process will only mean that, one way or another, valuable resources are wasted - with the most catastrophic waste occurring in the malinvestment of boom and bust.

Somewhat ironically, however, it is likely to be the free market that is characterised by relatively more stable prices than an economy burdened by the rollercoaster rides in asset prices caused by state induced inflation. Moreover, the existence of speculators – who gain a bad name in an environment of monetary inflation/deflation – would serve to prevent seasonal, irrational or capricious variations in prices and to smooth the transition between genuine price changes. No one, in other words, is likely to find that bread, cheese or milk costs twice as much today as they did yesterday.

Therefore, let us leave prices wholly to the free market so that we can create a genuinely stable and lasting economic prosperity.