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Why oil price hikes cannot cause inflation
Gerard Jackson
One of the most pervasive economic fallacies is that inflation is caused by rising prices, usually labour costs. Now the current economic myth being purveyed by our economic commentariat is that the Reserve Bank can maintain annual price rises at between 2-3 per cent, (which means cutting purchasing power by half every 24-35 years) provided there is no wage break-out or the economy runs into capacity constraints. None of this is true.
This brings to mind Mr John Hallows who wrote in the Herald-Sun
This view is dangerously wrong through and through. First a few facts. If those who push this line were right about the 1973 oil price hike causing inflation then the biggest oil importers would have had the highest price hikes. They did not.
For example, Germany and Japan are wholly dependent on oil imports, but after the price hike German inflation was only 7 per cent but Japan’s was 25 per cent. Australia, which was 75 per cent self-sufficient in oil, had an inflation rate of 17 per cent; America, which imported about 50 per cent of its oil, suffered a 12 per cent inflation rate; Britain, which had become a large oil producer, laboured under a record 25 per cent inflation rate; Saudi Arabia, the world’s largest oil exporter, saw its inflation shoot up to 35 per cent.
The view that oil prices caused inflation can not stand against the facts, which brings us to more facts. Those countries with the lowest rates of monetary growth enjoyed the lowest inflation rates. Take Britain and Japan as examples:inflation in Britain rose to 24 per cent and the money supply ran at over 25 per cent; Japan’s 25 per cent inflation was preceded by a 25 per cent monetary expansion.
What commentators like Hallows (and we do not seem to have any other kind in this country) failed to grasp is that external price shocks like the 1973 oil hike are basically deflationary. The very opposite of inflation. Furthermore, it’s absurd to claim that the Reserve caused stagflation because it could not distinguish between cost push and demand pull. This view reveals a staggering ignorance not only of the monetary facts of the time but also of advanced monetary theory and capital theory.
Oil price hikes can no more cause inflation than a general wage rise. If, for instance, unions succeeded in pushing wage costs above their market level the effect is not rising prices but mass unemployment. Anyone with a sound grasp of economics realises that there is no reason why prices in general should rise at all in such circumstances. The reasons are very simple.
Prices tend to be at the point of maximum net revenue, the supply of goods has not fallen and demand remains unchanged. Now it is important to recognise that general prices, i.e., the value of money, are determined by the supply and demand for money, just like any other commodity. Basically, therefore, for prices to rise one of three things must happen: (1) the demand for money must fall, (2) the supply of money must rise or (3) 1 and 2 must occur together.
It should be obvious that if businesses could have obtained higher prices for their products, they would have done so. They do not need unions to do the job for them. Businesspeople are not stupid, they are not going to deliberately keep prices at their lowest selling point; if the state of demand for their products allowed for higher prices then they would have taken advantage of that fact.
To do otherwise is not only irrational it would also create shortages because they would be pricing their products below the market clearing level.
The real reason why we get inflation should now be crystal clear. It is because governments expand money and credit. To put the issue very simply: if demand, which we measure in terms of money, does not change then the only way we can get a general price rise is for the supply of goods to fall.
This elementary fact reveals an important truth: changes in prices caused by changes in the supply of goods and services cannot be inflationary or deflationary. Inflation is a monetary problem; therefore only price increases caused by monetary expansion can rightfully be called inflation.
The difference between changes in prices caused by changes in the supply of goods and services and price changes caused by changes in the quantity of money are crucial to an understanding of our present economic circumstances.
It is a tragedy that so many of our economic and financial commentators are so ignorant of economic history as well as Austrian developments in monetary and capital theory. It really is time they started to do their homework. Or is that too much to ask?
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 18 April 2005