28 July 2008

Are Oil Prices Inflationary?

A commentor on Ed Brayton's blog claims that the recent high oil prices are "hyperinflation of a commodity." Of course it's not hyperinflation by any reasonable measure. Oil prices have roughly doubled--a 100% increase--in the last two years. In Germany, following WWI, they experienced inflation of around 300-400% per month. In several south American countries in the 1980s, the inflation rates were between 2,000 and 12,000% per year.

If 100% is "hyper," then I guess my first experience with hyperinflation was back in the '70s when the price of Bazooka Bubble Gum increased from 1 cent per piece to 2 cents.

The issue of real interest, however, is whether it is proper to call the increase in oil prices inflation? The commentor is not the only one to effectively call all price increases inflation, and a quick google search shows any number of articles linking oil prices and inflation.

Being influenced by the Austrian school, I dislike using the term inflation to refer to price increases caused by changes in supply or demand. Nothing is inflated there, because the real market value of the goods are being revealed by the price increases.

Inflation, proper, is the consequence of an increase in the money supply, an increase that is too great to be soaked up by increased production. Assuming, for example, that production is fixed, and no more can be produced. Then assume that overnight the money supply doubles. Since no more could be produced, prices would double. But goods would not be twice as valuable--the price increase would not reflect any increase in the value of the goods.

I think it is important to distinguish between the two types of price increases because they represent fundamentally different phenomena, and the appropriate response to each is fundamentally different. The proper response to real price increases is to conserve and purchase less, while the proper response to inflation is to reduce the money supply (as Fed Chair Paul Volcker did so successfully in 1981-2).

Furthermore, a rise in oil prices, even though it may cause an increase in costs for oil-dependent businesses, cannot cause an overall rise in prices unless the supply of money also increases. Because if the cost of oil goes up, and the supply of money remains fixed, then after buying oil (assume, for the moment, they buy the same amount), consumers have less money left over to buy other goods than they did before the price increase. If the price of something else--plastic containers, for example--also goes up because the price of oil goes up, they have again less money than before left over for other purchases. If all prices go up, consumers will have to purchase less. If consumers purchase less, goods will go unsold, and their prices must fall.

This is where politics and economics meet. Confusing the two causes of price increases leads to confusion about the proper political response. The appropriate political response to inflation is to reduce the money supply, while the appropriate political response to real price increases is to inform the public that it is real, and to disseminate information about ways to reduce their usage. Disseminating information is one of the things governments can do well.

Another appropriate action would be to improve the economic education in our elementary and high schools. The commentor on Dispatches accused me of an ad hominem attack on K-12 education. Far from being an ad hominem--I didn't accuse teachers of being stupid or lazy--I was just pointing out the regrettable fact that we don't teach much economics before college, and I think it's a disservice to our children. Supply and demand effects are easy to teach, and particularly appropriate to elementary school as they can be demonstrated with fun classroom activities. As long as most Americans think price controls are an effective cost to price increases (whether real or inflationary), that free trade makes us poorer, that subsidies help the economy, and that businesses can charge as much as they want, we'll never have have good economic policies. And, unfortunately, both our presidential candidates are true men of the masses on this score.


Scott Hanley said...

Ah, economics. There's a curriculum that would be less controversial than history and biology.

James K said...

Scott: True enough, I doubt either party would be keen to have economics taught to school pupils on a wide scale.

Steven Pinker once suggested a new focus for education that would do the most to undo the biases our evolution has endowed us with. The primary subjects were Biology, Economics, Statistics and Probability. Biology and economics help build the understanding that complex systems need not be the outcome of deliberate intentions and statistics and probability improve our rather abysmal intuitions about uncertainty.

Naturally I expect this curriculum to be adopted no sooner than 15 minutes after the sun burns out.

James Hanley said...


Be careful you don't accidentally bite your tongue when you've got it planted so deeply in your sleep.

I hadn't heard of Pinker's idea. As long as he kept writing skills, or just plain ol' literature, I'd be supportive. Particularly of probability--I have dreamed of requiring all incoming frosh at my college to take a course that focuses on probability. Naturally enough, only the science and economic faculty have any sympathy for the idea.

James K said...

Pinker's idea was to put more emphasis on those subjects, not teach these exclusively.

I know from personal experience that the statistics of undergraduates (even economics majors) can be pretty bad, as I had to teach some of them while I was at university, so I feel your pain.