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.