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Inflation fallacies, prices and houses
Gerard Jackson
Much economic commentary, particularly in our newspapers, makes for truly depressing reading so poor is much of the analysis. A fairly recent article in one of our so-called quality papers asserted that if fear of inflation became pervasive it would actually spark inflation by altering behaviour. For example, if someone wanted a house they would buy it now rather than wait for prices to rise. This would cause house prices to accelerate thus fuelling even more inflation. According to the author it was this process that caused inflation in the 1970s to accelerate. (And to think people get paid more than $100,000 a year for this nonsense).
Let us begin with first principles, something that many of economic commentator have evidently failed to master. If inflationary expectations cause demand for houses to rise this may raise house prices in the short term but not general prices. The reason is very simple, at least for reasonably intelligent people. In order to pay more for houses expenditure must be redirected from other goods. The effect, therefore, of paying more for houses is not to raise general prices but to exert a downward pressure on the prices of those goods from which demand has been redirected. This is simple enough to understand once we realise we can only spend the same dollar once.
This becomes clear when we consider that at any point in time there is a fixed supply of goods and money. Now if money supply is fixed then how can a general increase in prices occur without a surplus of goods emerging thus creating ‘excess capacity’? Put another way, how can the same quantity of goods whose prices have risen exchange against a fixed quantity of money? If a basket of goods sells, for example, at $200 then doubling its price means that only half of those goods can now be sold against the same $200, the remainder of the goods emerging as a surplus. Of course, our so-called sophisticated commentators can object that this is all too simplistic and the solution lies with an increase in the velocity of money. This view claims that no matter how much prices rise the output of goods can still be accommodated if people accelerate their spending so that the same number of dollars can clear the market at higher prices. All very neat (I never found it plausible) and very wrong.
Assume that a man has a net income of $500 the whole of which he spends throughout the week. It should be self-evident that even if he spends his income in a single day his average weekly spending remains unchanged as does his income. No matter how quickly he spends his income it cannot alter the fact that he can only spend it once. The same holds for everyone else. Even if everyone spent their incomes on the same day it would not mean a general rise in prices but a conclusion of all transactions on one particular day. Even if this were possible it ought be clear that this action is in no way inflationary. It should be obvious that ultimately individuals cannot increase their transactions without an increase in income. This means that the only way the number of transactions could rise against the same money income is if prices fell, meaning a real rise in money incomes has occurred. It also means that the only way prices can rise without a surplus of goods emerging is if money incomes are also rising.
So what was missing from our economic commentator’s article was the fundamental role of money. (Unfortunately, it is very rare for our economic commentators to mention money supply). There is no way general prices can continue rising unless the money supply expands, meaning that monetary expansion is what generates inflation. House prices can only continue to rise without exerting a downward pressure on other prices if the banking system has created enough bank credit.
(However, we can have situation where the value of a currency can drop to zero, meaning prices reach absurd heights, without the money supply increasing. This can occur where the currency is shortly expected to be terminated. In this case, the supply of goods will virtually disappear while those vendors who offer goods for sale will demand astronomical prices in the hope of making a quick gain before the currency ceases to be legal tender, which is not to say that exchanges will occur. This is what apparently happened in Manila in 1945. Once it was realised that the city was about to fall to the Americans the Japanese Peso completely lost its value and prices rocketed. This is the only case I know of something like this has happened. [New York Times, 30 January 1945]).
It is true that if people, fearing an inflation, rush to buy houses they will indeed suddenly bid them up. But if the money they use comes out of genuine savings and not phoney bank deposits the worst that can happen is that house prices will temporarily rise above their market prices and then fall back in the absence of sustained demand, forcing panicked buyers to suffer losses.
No wonder so much economic commentary is depressing.
Gerard Jackson is Brookes’ Economics Editor
BrookesNews.Com
Monday 25 September 2006