The biggest hoax in Economics: How CPI maintenance promotes inequality (Part I)
To question the validity of maintaining consumer prices is like questioning the fact that the Earth is the center of the Universe at a time when this was also believed to be true. Central Bankers believe stable consumer price inflation to be the center of gravity around which to formulate policy; instead of stable nominal incomes.
Economists don’t really seem to have an answer for inequality. Could this perhaps be due to having left the CPI maintenance stone unturned?
In this first series of essays, I will attempt to show how maintaining the CPI index is actually the root cause of inequality. Why does inequality tend to grow over time with dramatic and oftentimes traumatic resets after every so many decades or so? At the end of such times the debt slate becomes wiped clean and the income distribution field is leveled; often by some Great War where wealth is either confiscated or destroyed? After such events, the distribution of wealth gets a reset and a new Minsky debt cycle gets underway. During such resets World Power often shifts. After the Second World War, World Financial Capitals shifted from London to New York. Should we expect a shift of World Power from New York to Beijing next? Do we want to repeat such Centuries long cycles or do we have a chance to actually break free from them? One empirical fact that no seasoned Economist can fully explain today stands out: the common denominator underlying all such power shifts has invariably been a peak in inequality.
Such peaks, sudden collapses and slow build-up of inequality over the decades have been well documented by the French economist, Piketty in his tome, ‘Capital in the Twenty First Century’. If growing inequality is the motor for such cycles, how do we stop this motor?
Is inequality inherent to Capitalism?
Piketty seems to suggest that growing inequality is something inherent to the Capitalist system. I.e., it is unavoidable. He believes that only effective social redistribution policies with the aid of a World Central Authority will ever be able to keep the motor from overheating into the political arena, where the pendulum continues swinging from left to right and back again. Redistribution has become to be regarded as essential, as the natural forces of wealth and income distribution are believed to be inherently skewed.
However, by maintaining consumer prices or targeting some positive rate or inflation band (which makes matters worse), Central Banks foster an environment where money is surreptitiously transferred from consumers to capital owners. Why do so few economists actually see this? So firm must be their faith in the consumer price index that this is seldom ever questioned.
To be fair, what can be more alluring than associating stable prices with stability? Won’t people stop buying if prices were falling, knowing that they could always buy more cheaply later? Tell that to the tech junkies, that if they just waited a little while longer, they could get double the Gigs for half the price. We always see people patiently waiting for the price of television and hand phone sets to come down before they buy, don’t we? And if consumers were really so rational as Economists often assume in their models, why do they end up paying more for goods by paying a rate of interest on credit that exceeds the inflation rate; which means they could have paid less by simply waiting, but they didn’t?
Deflation is one of the biggest fears keeping Central Bankers up at night, not realizing that there is a distinction to be made between good and bad forms of deflation, just as there is a distinction between good and bad cholesterol. Good cholesterol is actually necessary to prevent the build up of bad cholesterol in the bloodstream. This analogy is very apt in describing the circular flow of the economy: we have a circular flow rapidly reaching a systemic buildup of debt on the verge of a stroke to the financial system, only because the Central Bank has indiscriminately thrown out the productivity-induced deflation baby with the all deflation bathwater.
I will try to make this as simple as possible assuming my audience is no more a seasoned economist than myself. So here goes: if, as an entrepreneur, I invent a new technique that allows me to make more of the same goods at a lower cost, why should the Central Bank insist on maintaining output prices? Say it cost me $100 to produce 10 widgets, which I can sell today at $12 a piece, why if I can produce 12 at the same total cost that I was able to produce 10 at previously, should I still be able to sell all 12 at $12 a piece, thereby increasing my profits by an additional $24? Nice, eh? I am still using the same amount of inputs in the form of raw materials and labour, but because of my innovation I can produce more output. I should have been able to make exactly the same amount of profits as before even by dropping my prices, allowing me to sell more without any need for the Central Bank to step in to create additional money.
Alas, that is not meant to be. Due to their fear of any price deflation whatsoever, the Central Bank will pump more money into the economy to hold unit prices up. In fact it is a general belief amongst Economists that money supply should always grow in line with productivity. It becomes a chicken and egg situation, because Economists base their belief on observing a correlation between money supply and productivity growth, believing this must therefore be empirically true, which of course it is, but only because the Central Banks made sure that money supply had kept up with output growth in the first place–by maintaining the CPI index!
What would have happened if they had let output prices slide naturally for such productivity induced gains–an abject heresy to a Central Banker–even though, as we had just seen, the entrepreneur can still make more profits by undercutting her competitors due to lower costs and increasing market share? But no, she is entitled to both the increase in market share and the full increase in profits, why forever not? In reality, one can never really tell which companies are set to gain more and which less, but added together it should be clear that all that ‘additional’ money created through the banking system to maintain CPI will ultimately end up in the hands of the companies as increased profits, thanks to the interventions of the Central Bank.
The nature of money
At this point I think it will be useful to back up and introduce a little monetary theory to get a better grip on the above process, especially in terms of how we are to define that ‘additional’ money. Money supply is generally some fixed amount of money that permanently circulates in the economy. We turn over the same money for a given circulation of goods. In other words money supply is fixed whereas consumption is a flow. We always consume so many barrels of oil per day or hotdogs per week. It’s never the same barrel of oil or hotdog that comes round twice. As long as this fixed amount of money keeps circulating, we have no problem with the circular flow of a constant stream of goods turning over for a fixed amount of money. But what happens if we all wanted to hold more money as float. Were money supply to remain fixed there would be a contraction in economic activity as, in my attempt to increase my money balance, I would have to cut back on my purchases, affecting your income and causing you to have less money for which you in turn would have to hold back even more purchases from the next guy in order to try and build up your own demand for money balance.
This is when it becomes useful for money to also have a bit of flow to it. For if 10 of us wanted $12 of money float each, having only started off with $10 each and there only being $100 going round, we’d all be playing musical chairs to get our hands on $12 knowing that some of us will come up short if an additional $20 didn’t also flow into the game (as we’d need $120 to have $12 each).
Central Banks have long caught onto this game. In fact they play this game much better than you think. They are so good at it that they even play it in your sleep. They soon realized that if they provided more than what people actually wanted to hold, they could even grease the wheels of the circular flow. If everyone only wanted to hold $12, that would mean that consumers would be quick to spend any amounts received over $12. And of course if only a certain amount of goods could be produced per period, prices would quickly rise as people bid away the excess money coming into their hands (note this spending could apply to either consumer or secondary markets assets spending; the critical point being how much people want to hold as float supporting both transactions streams).
Central Bankers think they are even cleverer than that. They will tell you that if it actually led to an increase in consumption, rather than an increase in prices, then they have actually done the World a favour! In fact, they will tell you it’s their job to do just that! That is why they monitor consumer prices in the first place.
Alas, we will have to park a rebuttal to that conviction for another time. For now, just to keep it as simple as possible, I will stick to the case of a rise in prices, which Economists appear unanimously in favour of over zero or any form of negative price inflation. That way we clearly begin to see the outline of the heart of the inequality problem we are digging towards, before our view gets fogged up again by all the real world overlay.
As we had seen above, the additional flow created by the Central Bank up and above what people needed as float so that no-one had to lose a chair, all ultimately flows into the hands of Capital, or capital owners. In other words the increase in cash, which at first seems to go to consumers for them to pay for the buoyed up prices of the increasing number of consumer goods, soon ends up on company balance sheets as extra profits earned by capital owners, which as we had seen a little while back, was not really required to incentivize them to innovate, as they would already be making more money and gaining market share due to lower costs, without the help of the Central Bank.
In this first essay, we have just started to scratch the surface of inequality plaguing the economy by showing how unwanted money created by the Central Bank model translates into excess profits that almost entirely flow to Capital (save for so much investment demand created that it puts upward pressure on wage rates as Capitalists fight over the available workers to game as much profits as possible from that unwanted money made available by the Central Bankers; a force that eventually dissipates as too much investment relative to long run sustainable employment is undertaken). However, to have a convincing argument able to stand up to the scrutiny of more seasoned economists than ourselves, we have more ground to cover. Yet the reader should be encouraged to know that we are already covering ground over which the seasoned Economists themselves are divided and terribly unclear about. The first series of essays will primarily deal with clarifying the problem at the root of inequality. A later series will have to deal with the solutions, some of which may already be suggesting themselves as we go along. Just be careful not to be swinging to the right or the left with your provisional thoughts, as the solutions of such political leanings are what we call boomerangs. They always swing back the other way as soon as they fail, which they invariably do, as will be explained by the end of this series.
The ultimate solution being aimed at here is one involving the de-politicization of the economy. I think the reason we find ourselves on this path of political polarization since the beginning of the Industrial Revolution, is that they started off Economics by calling it Political Economy. Although the prefix has long been dropped, its ghost of legacy continues to haunt us today.
In the second essay to this series, we will delve into the power imbalance between Capital and Labour and describe the essentials of how money is created.
Part II — On the power imbalance between Capital and Labour, how money is created and when does additional money lead to inflation and when not?
Part III — On money neutrality and the phenomenon of forced saving–how wealth is surreptitiously transferred from consumers to capital owners
Part IV — How the Central Bank affects the money supply, about over-indebting the consumer and on assets markets
Part V — Summary of a CPI maintained world
Part VI — A vision of a stable nominal incomes alternative reality
Part VII — Reinforcing the case of CPI maintenance leading to inequality
Robert Wutscher is an independent researcher.