What is Inflation?

I’m not sure what combination of carelessness, ignorance, malice, and/or rhetorical convenience causes Arthur Laffer to mischaracterize the Phillips curve, but…maybe I should be nicer, since I actually agree with Laffer’s main point.

Laffer is countering a view recently expressed several times on the same Opinion page (including by the Journal’s editors). Essentially, the argument he is rebutting goes something like this: “Prices are rising. Thus by definition we have inflation. The Fed should keep tightening in order to get rid of this inflation, before it becomes embedded in the system. The Fed has stopped tightening only because it sees (or expects) a slowdown, and because it believes in the Phillips curve, which says that a slowdown will reduce inflation. But we all know that the Phillips curve is a bunch of crap.”

Laffer begins his response by saying, in my broad paraphrase, “Ah, yes, we all do know that the Phillips curve is a bunch of crap, but…” He gets to the point by the end of the second paragraph (now I’m quoting literally):

…to confuse an increase in commodity prices with general inflation is a serious mistake, one which often seduces otherwise clear-thinking economists.

(I guess by “clear-thinking economists” he means those top-of-the-duffle-bag folks who don’t believe in such nonsense as the Phillips curve – a category which, as Donald Luskin points out, excludes the current Fed chairman. But I think a few of my fellow bottom-of-the-bag Keynesians might be confused as well.) I don’t agree with everything Laffer says subsequently (for example, why are “further declines in the dollar…not very likely,” considering that, after all, the “U.S. global capital surplus” that occasioned the decline has only gotten bigger?), but I take his main point to be about the definition of inflation.

The word “inflation” is essentially a metaphor: pushing money into the economy to produce higher prices is like blowing air into a balloon; it doesn’t add to the substance, but it makes the balloon look bigger. As a Keynesian, I do believe there are a lot of subtleties in the process: for example, the money doesn’t have to be pushed by the Fed or even by the banking system; it could be an increase in “velocity” occasioned by changes in preferences or “animal spirits.” And the economy doesn’t work quite like a balloon, because pushing money can in some cases increase the substance (because of sticky prices and wages). Thus I don’t think that growth in the monetary base, which Laffer charts, is a sufficient indicator of whether or not the Fed’s policy is inflationary.

But let me return to the metaphor. If the prices of volatile commodities are rising, and the prices of finished goods and services are rising at a slower rate than would be warranted by their commodity content (which is to say, the price of value added above those component commodities is not rising, at least not any faster than is considered normal), how does this resemble a balloon blowing up? Most of the balloon is not expanding. And if you examine the role of money, the flattening of the monetary base at the top of Laffer’s chart has actually had the effect of raising prices, by putting upward pressure on rental costs. It’s a very odd balloon that expands when you let the air out! It seems that, if we interpret the word “inflation” in keeping with this metaphorical etymology, it surely does not describe what is happening today.