It could happen here?

In case you missed it, the pundits of the Bank of International Settlements in Basle issued a stern rebuke to the Bank of England for its feckless policy of low interest rates (http://www.bis.org/).  Since interest rates in the United States are even lower than in the UK, the exclusion of the Federal Reserve from this rebuke gives an insight to geopolitics.  The anxieties of the BIS arise from "the logical conclusion that, at the global level, current monetary policy settings are inconsistent with price stability".  In other words, raise interest rates.
            In practical terms, barring that a central bank in one of the major countries will do something totally mad (an ever-present possibility, one might note), monetary policy will have no important impact on the current depressed state of the world economy.  Those countries whose governments have been sensible and introduced adequate fiscal stimuli will continue to grow, and the inhabitants of countries whose governments relying on "quantitative easing" will continue to suffer stagnation and/or decline.
        
In mainstream economics: inflation, deficits,       BIS official contemplating low
public debt and market regulation.                     interest rates.

            The significance of the statement from the BIS is not its rampant stupidity (though it is), nor its blatant support of financial interests (which it does, for they are bankers), but its manifestation of reactionary economic ideology.  The world economy is in recession, and the average unemployment rate across the five largest developed countries is over seven percent (see Table 1).  The BIS wants governments to raise interest rates to prevent inflation.  This defies parody, all the more so because there is no inflation to fight.

            As Table 2 shows, the average rate of change of price increases ("inflation") has been below one percent on a quarterly basis for the last year.  Even this low level is misleading, because a substantial part of that increase in all the countries came from increases in the prices of fuel and energy, the result of increases in world prices of petroleum and natural gas.  Because petroleum and gas are relatively homogenous products traded in international markets, there cannot be much cross country variation in their prices.  Therefore, when energy prices rise by six percent, as they did in the first quarter of this year, maintaining a constant price level in any country would require that other prices fall. 
            Further, a substantial portion of the price index in every country is made up of other raw materials determined in world markets, petroleum and gas being only the most obvious.  It follows that "price stability" requires forcing other prices down.  Forcing other prices down requires depressing output - recession.  If ever there were a case of the tail animating the hound, this is it:  purposefully depressing the domestic economy in response to international raw material prices.  I wonder what the BIS and those that agree with it would do if petroleum prices fell.

            Launching a price stability crusade because of international petroleum prices is only part of the madness.  A study in 1996 for the US Congress, the Boskin Report, concluded that the measure of inflation used in the United States over-estimated price increases by not systematically including new commodities and increases in the quality of existing commodities.  The report estimated this annual inflation bias to be slightly in excess of one percentage point (a summary can be found at http://www.ssa.gov/history/reports/boskinrpt.html).  This obviously sensible conclusion implies that we are in a period of gathering deflation, not inflation. 
            This nonsense of price stability defies economic good sense, and derives from the infamous Quantity Theory of Money.  This pseudo theory is based on the trivial definition that the sum of all transactions equals the sum of all means of payment for those transactions.  This trivial equality is assigned false content by assuming that all things bought and sold can be represented by one composite commodity, and all the different prices by one composite price (I am not making this up - go look at almost any economics textbook).  Assume further that the payment for all of these transactions is in the form of a homogenous, valueless entity named "money".   
            Well, with these fictions you are home free, so to speak.  In this imaginary world the following is true, PX = vM, with P the price of the composite commodity, X the amount of it, M is money, and v is the number of times each bit of money is used ("velocity" of money).  If the amount of X cannot increase and the "velocity" of money is constant, eureka! (as Archimedes might say), increases in the "quantity of money" result in increases in prices!  "Inflation is always and everywhere a monetary phenomenon" (as Milton Friedman did say), and any hint of "price instability" requires increased interest rates (alleged to decrease credit money).
            This analysis of inflation, in its simplistic or elaborated form is nonsense, theoretically unsound and empirical rubbish.  A fundamental logical flaw was pointed out in the 1930s by Don Patinkin (the False Dichotomy) and yet to be resolved.  More relevant for the non-specialist, every part of the analysis is an invalid concept.  There is no composite commodity.  The term PX is in reality the sum of many commodity prices times their amounts.  Many of these commodities are internationally traded and their prices are not determined domestically.  Others exchange where sellers have great market power to influence price movements.  Still other elements of the PX term are products and services whose prices may reflect short and medium term contracts.  In other words, real price indices are a mess of complexities that cannot be summarized in the metaphor of a composite commodity residing in a competitive market.
            Finally, there is no observable "M" corresponding to M = PX/v. This "money" is an imaginary inference implied by the equation itself.  Actual payments are made with credit cards, cash, checks, and promises to pay in the future (credit), to list the most common.  The suggestion that all these forms of payment can be aggregated and homogenized into the term "money supply" cannot even be called a hypothesis, because it cannot be empirically tested.  The "money supply causes inflation" ideology derives from this fiction, that all the means of payment are mechanically linked to credit operations of central banks.  The equally fallacious ideology that public deficits lead to inflation is merely an illogical extension of the alleged link between "the money supply" and inflation.
            The confusion and ideology obscuring rational discussion of monetary policy can be dispelled by repeating a common statement:
            Increases in the money supply cause inflation. This series of words has no meaning.  It is similar to saying, the sun shines on a sunny day.  To have meaning it requires a clear definition of money, explanation of what determines its supply, and specification of the empirical measure of price changes being used.  In a future comment I elaborate by considering the allegation that fiscal deficits cause inflation.
[More analytical detail and references can be found in the manuscript of my book, False Paradigm, available on jweeks.org under publications/economic theory, forthcoming with Routledge in 2012.]

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