Is protectionism inflationary?

No.

Protectionism is likely to distort some prices in the economy. But these (very likely) increased prices are not inflation.

I raise this point because an argument has broken out at Econlog between Scott Sumner and David Henderson.  Scott Sumner says “No” and David Henderson says “Yes”.  While I agree with Scott Sumner, I don’t agree with his reasoning.

I think they both define inflation incorrectly as being an increase in prices. Once we define inflation in these terms it becomes easy to fall into thinking about cost-push inflation and demand-pull inflation and the like. Rather we should think about inflation being a reduction in the value of money. That leads to prices increases, not price increases leading tautologically to a decline in the value of money.

So David Henderson’s argument goes like this:

One of the most valuable things Milton [Friedman] did was revive the quantity theory. It has its problems, but one virtue that remains is reminding us of the relationship MV = Py, where M is the money supply, V is the velocity of money, P is the price level, and y is real output (real GDP, in the current vernacular.)

Protectionism makes y, real GDP, lower than otherwise. Scott and I agree on that. With an unchanged M and unchanged V, P is higher than otherwise. Therefore an increase in protectionism causes an increase in P. We normally refer to an increase in P, the price level, as inflation.

So in this view anything that causes prices to rise  (ceteris paribus) is inflation and anything that causes prices to fall (ceteris paribus) is deflation. David Henderson continues:

But what about Milton Friedman’s famous line, “Inflation is always and everywhere a monetary phenomenon.” You can regard that statement as tautological because inflation, by definition, is a reduction in the value of money. But Milton meant much more than that: he meant that every inflation we could point to was caused by an increase in the money supply. He was probably right, but that’s an empirical statement, not a statement of necessity.

This is where David Henderson and I disagree. I don’t know if Milton Friedman thought “Inflation is always and everywhere a monetary phenomenon” as being an empirical statement or as a definition.  It seems to me that to accept David Henderson’s view is to strip the term inflation of any empirical content.

All this revolves around the definition of the word inflation. What is inflation? I have posted on this before and it is well-worth revisiting those thoughts (from 2011).

**~~**

Arthur Seldon defines inflation as ‘a fall in the value of money due to a persistent expansion in its quantity’. Ludwig von Mises wrote that ‘everyone knows’ that inflation is an increase in the quantity of money. Furthermore he wrote that ‘everyone knows’ that a general increase in prices is a consequence of inflation. Yet, inflation is often defined as a sustained increase in the general level of prices. This latter definition, however, is unsatisfactory. As von Mises has written, ‘What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency towards a rise or a fall in commodity prices and wage rates. This innovation is by no means harmless’. A sustained increase in prices is a symptom of inflation and not inflation itself.

This semantic difference is widespread. Milton Friedman, for example, has said, ‘By inflation, I shall mean a steady and sustained rise in prices’. Friedman goes on to claim that increases in the stock of money cause inflation. To be clear, Friedman argues, ‘more rapid increase in the quantity of money than in the quantity of goods and services available for purchase will produce inflation, raising prices in terms of that money’. Seldon, von Mises and Friedman agree that a general sustained increase in the average price level is caused by an increase in the quantity of money. Friedman, however, chooses to define inflation by the symptom, while Seldon and von Mises define inflation by its cause. As an aside, it worth indicating that Milton Friedman argues that government spending ‘may or may not’ be inflationary. The important source of inflation is deficit financing that is subsequently validated through the creation of money.

This semantic difference is important. Not all price increases are due to inflation. For example, the world price of oil has increased dramatically over the past few years. As a consequence petrol prices have increased, leading to increased transport costs and higher consumer prices. This is not inflation. It is true, however, that the Consumer Price Index (CPI) would have increased. Similarly, food prices have increased due to the drought – this too is not inflation. When the drought breaks, food prices will fall. Recall the banana crop failure of 2006. A tropical storm destroyed the Australian banana crop and the price of bananas rose to over $12.00 per kilogram. The price of substitute fruits also rose – yet in 2007 the price of bananas fell. Furthermore when economists advocate that water prices be increased to greater reflect scarcity and opportunity cost they are not advocating a policy of inflation.

Those price increases are what economists call changes in relative prices. They provide a signal to the market that certain goods and services are more valuable, and the supply of those good should be expanded. Conversely, they may signal that particular goods and services are now scarcer and should be conserved. An increase in the oil price, for example, signals that oil is now more valuable than it was before. Consumers should then use less of it, and producers should act to acquire more of it through exploration. Innovators should develop substitutes, and so on. The fact that inflation obscures price signals leads to economic inefficiency. In an inflationary environment, individuals cannot be sure that a price increase constitutes a market signal or inflation.

~~**~~

Update:  To be clear – we all agree that protectionism is bad economic policy.

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40 Responses to Is protectionism inflationary?

  1. mh

    Maybe if you were discussing Is Chinese Property Investment in Sydney Inflationary? your posts might be relevant.

  2. Tom

    Good thinking, Doomlord: base an entire post on the assumption that TrumpetyTrumpTrumpTrumpHitler is a regressive protectionist who will trigger a massive global economic depression even worst than the anemic recession we’ve been stuck in for the past decade. Trump is concerned simply that all trade deals signed by the US in the past 20 years have succeeded only in exporting US jobs — a massive policy failure. I believe he knows that re-erecting tariff barriers would be a disaster, but there are many other policy levers and deal-making available to him, such as lowering taxes, reducing the size of government and providing carrot-and-stick incentives for companies to stay onshore. In the meantime, the threat of protectionism is working wonders. I suggest you put more effort into understanding his strategy.

  3. Sinclair Davidson

    Tom – I saw a great meme on Facebook the other day. Having obsessions is good. Having just one is bad. Here I am venting one of my obsessions – what causes inflation (not protectionism, not trade unions, not Chinese property investors, etc.). Your single obsession “Trump is god” never occurred to me.

  4. Ray

    Inflation is concerned with the general price level, not the price of individual goods and services. Thus when Friedman argues that inflation is “a steady and sustained rise in prices”, he means general price levels and not the price of oil or bananas. As a result, the diversion into relative prices adds little to this discussion.

  5. Sinclair Davidson

    Friedman argues that inflation is “a steady and sustained rise in prices”, he means general price levels and not the price of oil or bananas.

    Yes – that’s what I think he meant too.

  6. Rabz

    Does protectionism lead to a decrease in consumer choice and purchasing power?

    Yes.

    Protectionism takes many forms.

    Exhibit A: The luxury car tax – one of the most indefensible taxes we’ve had “graciously” (i.e. for our own good) imposed on us by the morons people in this country keep electing to our legislatures.

  7. Ray

    Now for the substance of this issue. Inflation is a sustained increase in the general price level. Sure there are causes to this sustained increase in the general price level, and that cause is changes in the quantity of money relative to output in the economy. However, to define a sustained increase in the general price level as a persistent expansion in the quantity of money makes this whole exercise meaningless.

  8. Tom

    Your single obsession “Trump is god”

    Absolutely wrong, Doomie.

    I am attracted to the entirely of the story about the horrifying corruption of the US news media, its abandonment of ethics and the consequences for US politics, which are truly stupendous.

    Trump is god? Give me a break.

    What he is is a political outsiders making history doing something that has never been attempted before. It’s a hell of a story that the MSM is now incapable covering accurately because 80% of journalists consider themselves political players — king-makers — who think they have a divine right to make or break political leaders.

    They have lost the plot. They are destroying MY industry.

  9. Rabz

    he means general price levels

    For example the CPI is derived in this country by measuring price changes across “a basket of goods”.

    Here’s some instructive figures – the CPI figures at June 30 for the last five financial years:

    2012 1.2%
    2013 2.4%
    2014 3.0%
    2015 1.5%
    2016 1.0% (Dec 2015 to Dec 2016 figure is 1.5%)

    What these figures say in my opinion is that our economy is basically cactus.

  10. Ray

    So does protection add to inflation? The answer to that question will be it depends on factors other than protection. In an open economy with free capital movement and a floating exchange rate, any shift in demand for protected goods and services will affect demand for other goods and services.

    So if we protect a particular manufacturing industry, say cars, then the local price of cars will rise and the value of cars imported will fall. Ceteris paribus, the drop in imports means a rise in net exports and so an appreciation of the currency, resulting in a general drop in prices for imported goods which will largely offset the rise in the price of cars.

    Thus no rise in the general price level and so no inflation.

  11. Ray

    On the other hand, a closed economy with capital controls and a regulated exchange rate means that the local rise in car process will not be balanced by an appreciation in the currency. Instead, the central bank would be forced to step in to sell the local currency, increasing the volume of money in circulation. I think we can all agree that an increase in the quantity of money means inflation.

    Thus the inflationary effect of protection will very much depend upon the policy of the central bank. A floating exchange rate will mean no inflation while a fixed exchange rate will result in inflation.

  12. Ray

    Rabz

    An inflation rate of 1% does not make the economy cactus. Nor does 3%. Indeed, the headline rate of inflation does not matter at all. What is important is uncertainty.

    Davidson was correct when he noted that inflation disguises price signals. However, inflation does more than this, it adversely affects the need for business to maintain nominal price rigidity, it affects investment decisions and it affects consumer choices. If we had inflation of 20% and it remained consistent at that level for many years, that would be acceptable. What is not acceptable is inflation uncertainty, 1% this year, 10% next year.

    Of course deflation is unacceptable all the time, which is one of the reasons why we target a small positive number, given the variance across product groups and inaccuracies in estimation. Thus an outcome of 1% or 3% is hardly relevant.

  13. Rob MW

    Update: To be clear – we all agree that protectionism is bad economic policy.

    Except when you want the reluctant other side to pay their fair share of the damage unless, of course, you believe a competitor bringing an angry marshmallow to a gun fight has the upper hand.

  14. Rabz

    Ray, the economy is cactus. The low inflation rate is one indication of such.

    So if we protect a particular manufacturing industry, say cars, then the local price of cars will rise and the value of cars imported will fall.

    Err, no. The price of local cars will be artificially inflated due to factors such as high wages costs and lower levels of standard features, poor build, etc. In order to stimulate demand for these overpriced lemons, the price of imported cars must be artificially inflated to reduce demand for the latter.

    I can’t believe there are people on this blog who don’t get this.

  15. Rabz

    Sorry – meant to say the local cars will suffer from higher production costs (e.g. unrealistic wages extorted by unions) while being additionally burdened by a lower level of standard features and poor build etc.

  16. JC

    A floating exchange rate will mean no inflation while a fixed exchange rate will result in inflation.

    That’s just untrue. Any basic observation would show that fixed exchange rates are actually more likely to cause a deflationary spiral. It’s true that you can have both occurances with a fixed exchange rate, but you only have to look at the EU disaster to see that your assertion is bullshit on the deflationary argument.

  17. JC

    How does one distinguish between a change in relative prices and inflation? I’m asking because I believe te central banks made the fatal error in mistaking a change in relative prices for general inflation thereby causing the GFC.

  18. sfw

    Sinc, great post, this confusion about the meaning of inflation has made it difficult to know what a politician or economist is talking about sometimes. We really need a clear expression of what is the difference between a loss of purchasing power and an increase in some prices.

    Can you tell me what Reserve Banks are trying to achieve when they say they aim for say 2% annual inflation? Can you also tell me why this is regarded as a good thing, I really can’t find a rational explanation for it.

  19. RobK

    Thanks for that Sinc. Easy enough to understand.

  20. J-man

    MV=PY
    Sinc, you assume Y decreases on the basis of trade barriers. I am fine with that assumption. You then go on to state that V will be constant, or at least assume it will be. That is unreasonable. A simple look at an open economy that then restricts trade will reduce the demand for the currency of that economy. I think you could reasonably assume V will decline. So, for a fixed money supply and both V and Y declining, P could increase, decrease or stay the same.

  21. Ray

    JC

    You should be aware that the EU is not a fixed exchange rate. Some members of the EU have entered into a currency union arrangement, but the Euro is still floating on international markets. So I doubt if the performance of the EU in this regard proves anything.

    That being said, fixed exchange rates are likely to be more susceptible to inflation and or deflation than is a floating currency for the very reason I gave. To fix a currency, the central bank must buy or sell the local currency which means an increase or decrease in the quantity of money which means inflation or deflation. To put this simply, a country which makes a decision to fix their exchange rate, decides also to lose control over their money supply.

    Then again, none of this had anything to do with my comment. Read it in context. The discussion was purely over the effect of protection, nothing more and nothing less. It means that in an open economy, protection will not be inflationary because any domestic price rises will be offset by price decreases elsewhere. In a closed economy, on the other hand, the very nature of the fact that the central bank must intervene to maintain the currency means that protection could well induce inflation.

  22. JC

    Saw

    2% inflation target means for the US at least gliding the consumer cost index not the CPI at a 2% growth path.

    Ideally zero is best, but it’s very hard to achieve because you can always expect to hit the target all the time. Targeting zero would mean introducing frequent bouts of QE referred to as an unconventional tool. QE is something central banks try to avoid, so they had to pick a target which is low enough not to cause too much concern on the inflation front and high enough for markets to believe CBs will avoid QE/ deflation.

  23. JC

    Ray

    The EU has what they believe to be irrevocable fixed exchange
    rates.
    It means the national government has abrogated responsibility for monetary policy to someone else.

  24. Ray

    Rabz

    You seem to be having some trouble understanding that the sole purpose of a tariff is to raise the local price of imports. cars in this case. That means the price of cars on the local market will rise. This is a simple statement of fact. The reasons this needs to occur may well be due to the relative inefficiency of local production, but this is not the issue in question.

    The question was whether such protection, for whatever reason it is introduced, leads to inflation.

  25. JC

    JC

    You should be aware that the EU is not a fixed exchange rate. Some members of the EU have entered into a currency union arrangement, but the Euro is still floating on international markets. So I doubt if the performance of the EU in this regard proves anything.

    That’s because you’re an idiot, Ray. Just as Greece is fixed within the EU but floating against other currencies, Hong Kong is pegged to the Dollar but floating against others.

  26. JC

    I think the real question isn’t if protectionism leads to inflation. That’s really a second order issue. The real argument to be made against mates rates is the impact it has on living standards. Protectionism leads to falling living standards in relative terms.

  27. Rabz

    You seem to be having some trouble understanding that the sole purpose of a tariff is to raise the local price of imports. cars in this case. That means the price of cars on the local market will rise.

    From my comment at 2:25pm:

    In order to stimulate demand for these overpriced lemons, the price of imported cars must be artificially inflated to reduce demand for the latter.

  28. Rabz

    Protectionism leads to falling living standards in relative terms

    This is the nub of it and is a classic example of why Australia was such a backwater from the seventies onwards. Even Hawke recognised this.

  29. Ray

    JC

    I will try to explain this very carefully.

    There is no fixed exchange rate mechanism between EU countries. The only fixed exchange rate is between those members of the EU which have adopted the Euro. That would apply to 19 of the 28 countries in the EU.

    This means that the 19 countries of the Eurozone (not the EU) have, by adopting a fixed currency, fixed their exchange rates relative to each other. However, this is only relative to each other for the Euro itself is floating. As a result, the 19 countries have entered into a currency union not a fixed exchange rate.

  30. JC

    Ray

    I understand perfectly what monetary union is far better than you. The point that you seem to have missed is that while nations are contained within a monetary union, their spending, budget and wages policies differ greatly. The effect is the same on member states either in a monetary union or those having a fixed exchange rate. In other words they have lost control of monetary policy.
    I notice you’re no longer arguing the silly point that fixed exchange rates leads to inflation suggesting that wasn’t one of your important points. Unfortunately it was used to underpin the rest of your argument so it was worth ripping it down.

  31. Sinclair Davidson

    J-man – my argument revolves around inflation being caused by an increase in M. The rest of it a just a story as to why protectionism is bad.

  32. Ray

    JC

    That’s because you’re an idiot, Ray. Just as Greece is fixed within the EU but floating against other currencies, Hong Kong is pegged to the Dollar but floating against others.

    And that proves your point?

  33. .

    JC
    #2299566, posted on February 17, 2017 at 3:09 pm
    Saw

    2% inflation target means for the US at least gliding the consumer cost index not the CPI at a 2% growth path.

    Ideally zero is best

    Thank fuck for that. For months I thought you had darksided yourself.

  34. Ray

    JC

    I understand perfectly what monetary union is far better than you.

    Perhaps you do and perhaps you do not. But at least I understand the difference between the EU and the Eurozone and I trust you admit now that there is no fixed exchange rate mechanism inherent in the EU.

    That being said, I will wholeheartedly accept that a currency union may mean a loss of control over monetary policy by member states. Indeed, that is what has occurred in Europe, although this does not have to be the case where member states agree to strict controls over fiscal policy.

    However, this is a diversion which has very limited relevance to the inflationary impact of protection.

    Just to set the record straight, I never argued that fixed exchange rates lead to inflation. They certainly can given that such economies lose control over the money supply such that large capital or trade flows can result in either inflation or deflation. A point which I believe even you accept, or at least you did in your latest comment.

    What I did suggest is that the inflationary impact of protection applied to closed economies and not open economies. That means if a country with a floating exchange rate introduces a tariff, there is unlikely to be a resulting inflationary effect. However, if a country with a fixed exchange rate introduces a tariff, then there would likely be an inflationary effect.

    This is a somewhat narrow context than you inferred from my original post. Now I am all too ready to discuss the validity of this argument, but let us stick to what I have said rather than what you think you have read.

  35. Irreversible

    Anything that inhibits competition in the way protectionism does must induce inflation. Because it removes the discipline on employers to remain price competitive. So they don’t have to focus on cost. And therefore go soft on wage bargains.

  36. C. Paul Barreira

    cactus? gliding? local cars? M, V, P and y? inflation ≠ CPI? real GDP? ‘inflation disguises price signals’?
    Meanings appear stretched, to say the least.

    Consistent 20% ‘acceptable’. How did that—or something very like—work out in the 1920s in Germany? or Chile in the early 1970s? Chronic or hyperinflation represent appalling failures of government and popular ideas, with institutions following suit.

    Oz in the mid-70s had 20 and more per cent. inflation. I remember my father being astonished as clerk of Coonalpyn Downs District Council when he concluded that the forthcoming year’s budget had to allow for 21 or 22 per cent inflation. He was out by one per cent, up or below I don’t precisely recall. ‘Acceptable’, as a way of life? No.

    Today we have inflation from another source: inept and ever cheaper—meaning nastier—manufacturing. Our kitchen kettle in the twentieth century lasted 20 years. Now less than two. TVs were good for decades; now, I’m told by a retailer, perhaps three years only. Refrigerators dead in five. And so it goes on. Even the landline phone will shortly no longer work. Oops, witch of another colour—except for the cost.

    Whatever people call economic growth is a fraud because the goods and services that make for economic life have rapidly decreasing value. The numbers for 2012–2016 are but a tiny fraction of the real increase in costs and thus of speedy, ever-reducing standard of living. And despite being in SA I’ve not mentioned electricity. Nuff said.

  37. mh

    Here I am venting one of my obsessions – what causes inflation (not protectionism, not trade unions, not Chinese property investors, etc.)

    You are not interested in asset inflation, Sinclair?

  38. JC

    Perhaps you do and perhaps you do not. But at least I understand the difference between the EU and the Eurozone and I trust you admit now that there is no fixed exchange rate mechanism inherent in the EU.

    Of course there are differences between monetary union and a fixed exchange rate. One is supposed to be immutable and the other is sort of. My point though remains the same in that the potential impacts are virtually identical…. in that monetary policy management is handed over to another CB.

    That being said, I will wholeheartedly accept that a currency union may mean a loss of control over monetary policy by member states.

    May mean? It’s doesn’t “may mean”, it’s total.

    Indeed, that is what has occurred in Europe, although this does not have to be the case where member states agree to strict controls over fiscal policy.

    Oh yea, the Maastricht treaty limiting budget deficits and massive fines above the prescribed ceiling. That worked 🙂

    What I did suggest is that the inflationary impact of protection applied to closed economies and not open economies. That means if a country with a floating exchange rate introduces a tariff, there is unlikely to be a resulting inflationary effect. However, if a country with a fixed exchange rate introduces a tariff, then there would likely be an inflationary effect.

    That’s not correct. If a country pursues an inflationary policy it can do so under a floating regime. Hell, it’s easier to run such a policy under floating. Witness Australia in the 80’s after the float. There was everything . Loose monetary policy, tariffs, inflationary wages policy and a compliant central bank.

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