The True Meaning Of Inflation -

John Tamny, 01.25.10, 12:00 AM EST

Prices aren't an accurate measure

Seeking to provide clarity as to the true meaning of inflation, the late Nobel Laureate Milton Friedman

helpfully described it as "always and everywhere a monetary phenomenon." At first glance Friedman's definition is hard to improve on--from post-WWI Germany to the 1970s in the United States and modern-day Zimbabwe, inflation has always been a monetary symptom of collapsing currency values.

The problem, however, is that Friedman was actually defining something quite different. In the monetarist model that he practiced, money growth beyond a pre-set point was inflation. Friedman's point was that money quantities themselves always told the inflationary tale. But did they?

In truth, the Fed's monetary base grew the same in the 1970s as it did in the 1980s, with two completely different results. The dollar was weak in the 1970s, as evidenced by a skyrocketing gold price, whereas in the '80s the price of gold fell. It should be noted that Friedman, captive to money supply targets, warned of renewed inflationary pressures in the mid-1980s that were surely belied by a very strong dollar.

The Federal Reserve is empowered by Congress to keep inflation in check, but its definition is even more wanting than the monetarist view. According to the Fed's leading lights--including Chairman Ben Bernanke--inflation is a function of too much economic growth. This impoverishing definition is even easier to discredit than the monetarist description.

In an increasingly interconnected global economy, shortages of labor and manufacturing capacity in any one country cannot be inflationary. They can't because, as we've regularly seen with U.S. companies, they have always accessed the world's supply of labor and capacity when producing the goods we buy. Even if we assume--as the Fed seemingly does--that the U.S. economy is closed the Fed's definition still wouldn't pass the most basic of scrutiny.

Indeed, labor shortages in any one country are always solved by new labor force entrants seeking to achieve the higher pay created by shortages, by the certain migration of workers from weak to strong labor markets and--most notably--by technological innovations that reduce the need for human labor inputs. High capacity utilization is nothing more than a market signal suggesting more is needed. And because of robotics and other production innovations, capacity is hardly a static concept...