Editorial

Inflation, Employment and Money

by Fred E. Foldvary, Senior Editor

The economy of the United States is booming, and wages are starting to rise. Many economists fear that wage increases will push prices up, and that this inflation should be stopped. The way inflation is typically dealt with is to raise interest rates to reduce investment, slow down the growth of the economy, and so hold down that nasty inflation. If that reduces employment, the conventional thought goes, that's the price of reducing inflation, as inflation is worse in the long run.

Economists have a name for the relationship between unemployment and inflation, the "Phillips Curve," named after an economist who found a connection between wage increases and unemployment. When unemployment is low, wages tend to rise faster than when unemployment is high. This is evident, but there is a problem when policy-makers try to use this relationship to reduce inflation.

First of all, there are two types of inflation, monetary inflation and price inflation. Monetary inflation is a too-high growth in the money supply. Price inflation is a continuing increase in prices. Monetary inflation causes price inflation, but price inflation can be caused by other economic forces. As productivity increases and labor becomes in short supply in some fields, some wages will rise, and this is not an economic problem. Why not have labor get its share of prosperity?

Wage increases today are no cause for alarm. Profits have been high, rents are increasing, and labor is due its share of the wealth. If wage increases are due to shortages of labor, that by itself is not price-inflationary in the long run, since this signals that workers should enter the fields where wages are rising, and it signals to employers that labor resources are less available short-term.

The big problem for the Federal Reserve or any central bank controlling the money supply is how to determine when price inflation has been caused by monetary inflation. The big question is how fast to increase the money supply. Expanding money too much causes monetary inflation, and expanding too slow increases interest rates in the short run and may cause a recession. The key problem is that there is no way for anyone to know the correct amount of money expansion. The FED can be credited for the relatively low rate of inflation recently, but maybe it was just lucky or perhaps there is a mountain of money sitting that can hit the consumer markets and start inflation rolling. Nobody knows.

Fear of inflation meanwhile puts a break on economic expansion. Whenever the economy "heats up," economists in and out of the FED get worried about inflation and want to step on the breaks. That's why the stock market tends to go down whenever the economic news is too good: the FED can stop the party at any time.

Is there any alternative to this constant teetering between inflation and unemployment? There is, but it requires a rather big institutional change: abolish the central bank. Eliminate government control over the money supply. If central planning does not work in the market for goods, why would it succeed in the monetary and banking market? If free markets are efficient, why not also in money and banking?

Free-market banking, or "free banking," would remove all restrictions on interstate branches, and banks would issue money instead of the government. The way this would work is that the amount of government dollars would be frozen, and all future increases would be with private bank notes.

Free banking would stop monetary inflation, providing just that amount of money the public wants to hold. The reason for this is that private banknotes would be redeemed for the notes of other banks or for government money. If Bank X prints too much money, it would just come back to the bank for conversion into federal reserve notes or the notes of another bank. It was the conversion of banknotes into gold that prevented inflation under a gold standard. The same would happen with free banking.

Free banking would be a big reform, and it won't happen unless the public understands what it is. We've been lucky for the past few years, but the good luck won't continue forever. Economists blame the FED for making the Great Depression of the 1930s worse than it had to be, and the FED is blamed for the great inflation of the 1970s. Is it good to have the entire economy depend on the wisdom of a few men who cannot possibly know the correct amount of money to provide, or to let the market provide the money according to the desires of the public? The public should at least become aware of the alternative of free banking. So now you know.