Inflating the Substitution Effect
Inflation is reported -- and thought of -- as the percentage increase in prices or the declining value of money. This is visible. But it is only one side of the story. What follows is an exploration of inflation without reference to prices.

On June 28, 1978, Federal Reserve Governor Henry C. Wallich addressed the graduating class at Fordham Graduate School of Business in New York. Inflation was on everyone’s mind and Wallich was forthcoming. “Inflation,” he informed the young and idealistic graduates, “is a means by which the strong can more effectively exploit the weak. The strategically positioned and well-organized can gain at the expense of the unorganized and the aged.”

How is this so? Wallich explained inflation, “is technically an economic problem. I mean the breakdown in our standards of measuring economic values, as a consequence of inflation.” The strong are smart enough to understand that inflation “introduces an element of deceit into most of our economic dealings.” Contracts are no longer made to “be kept in terms of constant values,” but one party understands this better than the other. Contracts during a period of inflation are made with monetary terms “unpredictably shifting measures of weight, time or space…”

General Mills understands this. The maker of Wheaties and Lucky Charms has passed on the rising cost of grains without raising retail prices. It tried to increase prices in early 2005, and sales of some cereals fell by 5%. This time around, it is attempting if not a deceitful maneuver, one that is clever. According to the Minneapolis StarTribune.com: “Customers will actually see lower prices per box, but the boxes will be smaller, so the effect is a price increase of a few percent.” The price increase is murky, but evident.
Wallich grew up in Germany and survived the 1923 hyperinflation (excellent training for any central banker). In his adopted country, Wallich watched the deterioration of product quality during the inflationary 1970s. A 1966 Lou Harris Poll found that 75% of respondents thought American goods were of “good” or “excellent” quality. By 1971, this had fallen to 47%. In 1977, 27% would not buy the products they made. And so it is today. In May, The New York Times submitted a pier-front report from Madeira Beach, Fla., the “grouper capital of the world.” Its reporter found that “seven of 24 [restaurants] were passing off cheaper imported fish -- tilapia…hake…painted sweetlips [and other fish with names too gruesome to mention] -- as grouper.”

Fishing restrictions are one problem, but more so are higher fuel costs and condominium development that is “taking over the waterfront.” Here we find the nexus of higher energy costs, cheap money, bad food, and exploitation. Since unlimited credit gave every Florida fisherman the wherewithal to buy a waterfront condo, there is no place to moor a boat. This is not just a local problem. The Holbrook Community Foundation in Harpswell, Maine, is raising money to save Holbrook’s Wharf, a fishing pier for decades. The foundation was “fearful the property would be sold and converted to what locals call a ‘McMansion.’” This is not an idle fear. The Portland Press Herald reports: “Just 20 miles of Maine’s 5,300-mile coastline is classified as ‘working waterfront,’ and much of that is vulnerable to development that could limit access further.” From personal observation, poorly constructed condominium projects have replaced former Maine fishing villages that fade from memory.

Wallich warned that inflation substitutes government for liberty: “Inflation becomes a means of exploiting labor’s money illusion.” Among the winners, from the mouth of this public servant, is government. “It allows the politician to make promises that cannot be met in real terms, because, as the government overspends trying to keep those promises, the value of the benefits it delivers shrinks.” This creates a “diminishing ability of households to provide privately for their future…One may indeed ask whether it is not an essential attribute of a civilized society to be able to make that kind of provision for the future.” Wallich went on to emphasize that “the increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government.” So we have the public panic concerning Social Security and health insurance today.

Wallich continued. Inflation “creates a vacuum in the private sector into which the government moves.” Today, the tendency is to expect government to solve the health insurance dilemma. Yet the visible effect of greater government involvement in health care has been higher costs and a suffocating bureaucracy of paperwork. The Federal Reserve governor worried that the consequences of inflation would be “a shift also in the third dimension, away from democracy and toward authoritarianism.” Wallich’s question was more than theoretical. The German, post-World War I hyperinflation wiped out the middle class, the consequences of which were not Arcadian.

Continued Tomorrow.