(Originally posted on Mises.org)
“Homebuilding rebounded less than expected,” NBC reported recently, “as very expensive lumber and shortages of other materials continued to constrain builders’ ability to take advantage of an acute shortage of houses on the market.”
Lumber isn’t the only material that has experienced significant price increases over the past year. The same NBC article notes that steel and copper prices are also hampering the housing market. The general pattern of price inflation is that higher-order goods—those furthest from the consumer in the production process—tend to react sooner and more significantly to changes in the money supply. We can see this trend in the dramatic disparity between the Producer Price Index (PPI) and Consumer Price Index (CPI).
When people discuss inflation, they rarely have in mind monetary expansion, which is an important driver of price inflation. Instead, they think almost exclusively of consumer prices.
The Myth of Monetary Neutrality
The theory of monetary neutrality justifies this mindset, under the assumption that prices adjust evenly to changes in the money supply. Monetary neutrality is a relic of the age before the marginal revolution, when objective theories of value—most notably the labor theory of value—were standard among economic thinkers, including liberals such as Adam Smith. In fact, this idea was given early expression by one of Smith’s greatest influences, David Hume, who posed a thought experiment in his Political Discourses:
Suppose, that, by miracle, every man in Britain should have five pounds slipt into his pocket in one night: this would much more than double the whole money that is at present in the kingdom; and yet there would not next day, nor for some time, be any more lenders, nor any variation in the interest. And were there nothing but landlords and peasants in the state, this money, however abundant, could never gather into sums; and would only serve to increase the prices of every thing, without any farther consequence.1
This idea made sense under theories of objective value; prices should always trend toward their “natural” value, derived from the same original source of value (labor), so equilibrium prices would logically adjust proportionately. Two decades before Hume offered this thought experiment, Richard Cantillon, a French physiocrat, had already shown that this assumption didn’t hold in the real world, where prices adjusted unevenly—a phenomenon that now bears his name: the Cantillon effects.2
After the marginal revolution, economists gradually accepted the subjective theory of value, but the Austrian economists have been virtually alone in considering the implications this held for classical theory. For this reason, Austrian economics is the only school of thought that rejects monetary neutrality for its inability to explain real-world prices.
The Problem with Unrealistic Mainstream Assumptions
Mainstream economists, by contrast, will defend monetary neutrality as an “unrealistic assumption” that “approximates reality.” This is the standard explanation for problematic economic assumptions, as there is no way of objectively defining what constitutes a sufficient “approximation” of the real world, but the graph shown above might call into question the usefulness of this assumption. If it approximates reality, we should expect to see the PPI and CPI reasonably close together and following roughly the same pattern of change. Instead, what we see is remarkable volatility, with the PPI fluctuating wildly from the CPI and often in the opposite direction. What reality, then, does monetary neutrality approximate?
Standard economic theory is unable to explain this, outside of particularistic explanations that offer no insight about general economic phenomena. The current excuse for the current dramatic disparity in price indices is (of course) covid-19. The pandemic, so goes the explanation, disrupted the economy, leading to a scarcity of goods, thus driving up the price of lumber, steel, and other producer goods. Covid—or, more accurately, governments’ response to the pandemic—certainly did disrupt the economy, but this still fails to explain why the CPI was less affected by these disruptions than the PPI.
The massive expansion of credit over the past year, largely driven by President Trump’s record-breaking stimulus bill prior to his abrupt change in attitude toward lockdown policies, also offers an explanation for price inflation, but this again fails to explain the disparity between the indices.
Why Consumer Prices and Producer Prices Are So Different
Austrian economics is again alone in its ability to explain this phenomenon. Because Austrians consider time a relevant variable in economic theory, they recognize that credit expansion, by artificially lowering interest rates, will encourage businesses to assume debt to expand lines of production, therefore shifting resources toward the higher stages of production. This means the new dollars are disproportionately spent on producer goods. Understanding this point is what allowed Ron Paul, writing of Alan Greenspan’s policy of setting the target interest rate at 1 percent, to note in 2002 that “it is well established that, under certain circumstances, new credit inflation can find its way into the stock or real estate market, as it did in the 1920s, while consumer prices remain relatively stable.” In 2008, when Ben Bernanke was defending the Federal Reserve’s track record of maintaining stable prices, Paul pointed out that the PPI was at a whopping 12 percent, a figure far exceeding the CPI numbers that the Fed chairman was touting.
The dismal implication of the PPI-CPI comparison in the above graph is that the last time we saw a disproportionate spike in PPI similar to what we’re facing now was in 2008. The policy of the Federal Reserve over the past year has been, in conjunction with the federal government, to pump money into the economy to prop up the stock market. Failing to learn any lessons from past crises, both Republicans and Democrats overwhelmingly accept the fallacy that the stock market is an indicator of economic health.
- 1.David Hume, Hume’s Political Discourses (Lenox, MA: Hardpress Publishing, 2012), p. 43.
- 2.To avoid potential confusion in my chronology, Cantillon’s treatise was published three years after Hume’s Discourses, but it was common for manuscripts to circulate among European intellectuals for years before publication, and the Enlightenment Scots borrowed heavily from French economists in other areas, so it is not unlikely that Hume was familiar with Cantillon’s work.
Chris Calton is a 2018 Mises Institute Research Fellow and an economic historian. He is writer and host of the Historical Controversies podcast.
See also his YouTube channel here.