Economists have long debated the costs and benefits of stabilizing the purchasing power of money. Today, most First World countries’ central banks either pursue the stabilization of purchasing power as a primary goal, as in the case of the European Central Bank (technically, the stabilization of the rate of change of money’s purchasing power, by means of an inflation target), or they balance it against a series of other goals, as in the case of the U.S. Federal Reserve and its “dual mandate” (stable prices and maximum employment).
The argument in favor of stable purchasing power is simple and attractive. Money is the yardstick of commercial life. To create an environment conducive to economic growth, both producers and consumers need a fundamental unit, akin to a weight or measure, with which they can compute the relative merits of various economic activities. If money’s purchasing power isn’t stable, there is no common denominator, thus rendering computations more costly to make. It would be like trying to run a 5k road race with the definition of a kilometer constantly in flux. Runners would not know how to pace themselves to complete the race in the best time possible. Only if the definition of a kilometer is known and fixed in advance is the race an appropriate environment for determining the winner on the basis of athletic prowess rather than luck. So it goes with money. Only if the purchasing power of money is stable, the argument goes, will the environment that is the competitive market process select systematically for activities that exhaust the gains from trade.
However, the above is only part of the story. It’s true that stabilizing the purchasing power of money would make navigating commercial life easier much of the time. But before we conclude that stabilizing money’s purchasing power is a good idea, we need to recognize an important point about the use of money in an advanced economy characterized by an extensive division of labor. It’s well known that the private-property market economy creates an impressive knowledge-generating system, namely, the price system. Prices convey relative resource scarcities to producers and consumers; at the same time they economize on the information any one producer or consumer needs to systematically capture gains from trade. When the economy has a generally accepted medium of exchange, what we call money, prices typically are quoted in X units of the medium of exchange per Y units of a good or service. Those prices are the money price of goods. But what, then, is the price of money?
The price of money
To answer that question, we must recognize something important: Money has no market of its own in which it is independently priced. The price of money is simply the reciprocal of its purchasing power, which itself comprises the prices of all the goods and services that a consumer typically purchases. Goods and services are priced in terms of money, and money is priced in terms of goods and services. That means that adjustments in the money market, i.e., conditions where there is an excess supply or demand of money at its current price, cannot neutralize themselves in the same way they typically do in other markets. If there is an excess demand for apples at the current price of apples, the (money) price of apples will rise to clear the market. But because money has no market of its own, the price of money can be brought into adjustment only by the changing of many, many relative prices throughout the economy.
That brings us to an important issue that proponents of stable money overlook. The price system cannot exclude the role of money in accumulating and disseminating information. Money is a good, and its price ought to change when underlying supply and demand conditions in the money market, and thus other markets as well, change. To mask those changes would interfere with the price system’s ability to communicate relative resource scarcities. Money isn’t just a yardstick. It also is the economy’s chief facilitator of trade. If the price system is to do its job, when trade conditions change, so must the conditions under which money is traded for goods and services.
Here’s an example. Suppose, owing to general increases in technological progress, the supply of goods and services produced increases over time. That makes sense because better technology means getting more output for a given amount of input. What should happen to the prices of those goods and services? If all else is held constant, including the supply of money, prices should fall. The same stock of money chasing larger stocks of goods and services means that each good or service must “bid” lower for each unit of money. The result is a fall in prices across the economy, with each industry’s price falling in proportion to the degree that technological progress raised that particular industry’s output. That increase in the purchasing power of money is facilitated at the micro level by an economywide adjustment of relative prices. (In fact, the latter part of the 19th century was a period of healthily growing output and slowly but steadily falling prices in the United States, since the money stock was mostly fixed because of the gold standard. The result was that many economic historians in the early and mid 20th century fallaciously concluded that the United States was in a decades-long recession.)
Now imagine that the country’s central bank is pursuing a policy of purchasing-power stabilization. In response to falling prices, it injects money into the economy in an attempt to counteract deflation, which it sees as potentially dangerous. The new money won’t spread throughout the economy evenly. The first recipients of it will spend the excess (the amount over what they wish to hold as cash) on goods and services that they find most useful. That increases demand in specific industries at the time, and in those industries only. That in turn affects the economic activity of many other participants in the market, since demand conditions in one market necessarily affect conditions in others. When the second recipients of the new money receive it, the process repeats itself. Eventually, as the money makes its way throughout the economy, upward pressure on more and more prices results. But because of the process that was followed, there won’t be a uniform effect on all prices. That makes it even more difficult for affairs to be put right in the money market, which necessarily places a strain on the price system. Relative prices will be struggling to reconcile the effects of the technological increase with the effects of the money injection. Rather than allow the price of money to adjust by means of economywide price adjustments, the central bank has now made it harder for economic actors to capture gains from trade.
Nobody familiar with basic economic theory would suggest stabilizing the price of oil or platinum to make the prices of those commodities predictable. Like all prices, the prices of crucial inputs can and must change to reflect changing supply and demand conditions. The same is true of money. Preventing the price of money — the inverse of its purchasing power — from adjusting won’t result in an environment conducive to commercial activity. Instead, misguided attempts to stabilize the price of money directly will hinder money-using individuals’ ability to participate in the division of labor and secure gains from trade.
This article was originally published in the August 2013 edition of Future of Freedom.