Friday, October 26, 2007

Fricke's mercantilist mumbo jumbo (amv)

Thomas Fricke is "chief economist" of the newspaper Financial Times Deutschland (FTD). Together with Sebastian Dullien and others he operates the blog Wirtschaftswunder which is a pretty good example of economics that went astray. His most recent contribution is headed "Be happy, prices are soaring!" Juhu. Good news, isn't it? Let us see why Fricke thinks that we should be happy about rising inflation:

We should be happy about inflation, because it simply reflects Germany's higher preferences for education (and thus for student fees in addition to the 'normal' running costs on higher education which in turn increase the overall cost of education). Since a lot of economists think that more higher education is fine, Fricke concludes that inflation based on higher educational costs is the price we have to pay (Quote: "Inflation makes students smart." - Are you serious?). Further, inflation is due to higher costs in agricultural production. Why is this a good thing? Because it again reflects a change in Germany's preferences, this time in favor of measures against climate change (more cropland for canola, less for bread). Finally we should be happy about German inflation because one sort of cost which drives up the price level is the outlay for natural resources. Thus, inflation is a kind of foreign aid to, e.g., Latin America. Then, don't forget that sales taxes have been raised recently. But the inflation thereby caused (to our students: don't forget, this is just a one-time effect) is again a good thing: at least the budget is after a long time consolidated. Finally, we should be happy about inflation because growth has to be accompanied by inflation. The rise in all prices is a sign of economic health, of general human betterment. Thus Fricke returns to pre-1970's economics in simply stating a trade-off between growth and stable money (he does not even refrain from using Helmut Schmidt's infamous statement about this trade-off)! All this cost-push effects on inflation he calls "good inflation" compared with "bad inflation" which is the merely the residual after "good inflation" is subtracted from actual inflation. But why is "bad inflation" actually bad? Fricke tells us: because it hampers the growth of real wages which are - as the Keynesian saga goes - the main driver of human welfare! So what is the solution to bad inflation: it is not in Fricke but it is obvious. Increase money wages! Fight bad inflation with good inflation.

This is really poor economics! Let us for a moment assume that the circulating money supply is held constant, just to abstract from monetary effects which may disturb the real forces operating. To claim that money in circulation is constant one is actually claiming that aggregate demand is constant! Now, let us see what happens if, for example, we face a change in preferences - e.g. shifting towards climate-friendly technologies by using more of the same cropland for canola instead of bread production. What happens? Given the aggregate budget-constraint (because money in circulation is given), a shift in preferences implies a reallocation of resources. Even though initially the demand for bread may not have changed, there is now an additional demand for the limited cropland, on which bread and energy-saving argricultural products can alternatively be produced, but on which only bread-producing resources were so far employed. This demand allows the producers of energy-saving technologies (here of canola) to bid away the cropland from the production of bread. Land is reallocated so as to maximize consumers' utility. Now the relative price of land which can alternatively be used to produce canola has risen. The relative price for bread has fallen even though the absolut money price of bread might have risen too due to a rise in money costs. This of course, also depends on the elasticities of demand. Maybe bread production has to be cut back until a higher marginal product allows to pay the higher resource costs. But if the demand for bread is inelastic, the use of some other consumption good becomes submarginal - at least submarginal in respect to the intensity of its use relative to other uses - and is therefore scaled back or altogether abolished). We face the ultimate fact of economic life and the centerpiece of economic theory: we have to choose and to substitute since our ends are unlimited while our means are scarce! We face a change in relative prices and since the relation between money in circulation and real output did not change, the price level is still fixed on the initial level. The same applies to a shift in preference in favor of education, foreign aid or whatever. A change in the path of inflation cannot be explained by those shifts. Indeed, it is fallacious to do so.

But imagine what happens if all these preference shifts are accompanied by expansions of money in circulation. For given real income growth only monetary expansion can lead to absolute adjustments of prices. Initially the necessity to substitute, that is the necessity to choose in a world with unlimited ends and scarce means, is eliminated by the mere shift in the budget constraints. Yet, and this is crucial, more money allows the individual to purchase more, but more money cannot allow the society as such to consume more. More money is no substitute for real forces increasing our riches. Or does to supply of means to achieve our ends increase when money suplly increases? Fricke commits mercantilistic mumbo jumbo by confusing more money with general betterment.

If money is proportionately increased, indeed nothing changes at all. All budget constraint shift together, all members of a society drive together to the supermarket, all of them with more money, and since all have proportionately more money, the respective shares of the cake - as they existed before monetary expansion - cannot be changed by anybody. This is the neutrality postulate. Of course, it is unlikely that money is increased by the helicopter-effect. In reality, the increase in money supply is disproportionally distributed, that is, some will get the money first and more of it. Those who are early receivers can bid away resources from those who get the additional money late. Since the late receivers are workers and the early receivers mostly capital owners, inflation is accompanied with the redistribution from the poor to the rich.

Juhu, Mr. Fricke? Still happy with rising inflation?

To conclude: Economics is about the allocation of scarce means to given and unlimited ends so as to increase consumer welfare in general. But then I don't know what Fricke - the chief economist - is doing! Certainly, it is not economics proper.