We live in an era of macroeconomic superstition. Much of what commentators think they know about monetary policy just ain’t so. A recent example is the purported link between economic growth and inflation. In a recent Wall Street Journal article, David Harrison warned that the Fed may continue “to fight inflation by slowing growth.” The Fed is trying for a soft landing, but economic vigor apparently clutters the runway.
If I had any hair left, I’d pull it out. Stronger growth isn’t inflationary. If anything, a growing economy slows dollar depreciation. The tradeoff between a strong economy and a strong dollar is illusory. We can have both.
Inflationary growth is merely the latest manifestation of vulgar demand-side fundamentalism. The kernel of truth here is that stronger spending growth can sometimes produce temporarily stronger output growth. If total expenditure throughout the economy rises, both prices and output should rise—hence the assumed connection between inflation and growth.
But spending-induced economic growth can’t last. Our ability to produce is constrained by the availability of labor, capital, and natural resources, the efficacy of technology, and the commercial friendliness of laws and institutions. Passing dollars back and forth doesn’t change any of these. Eventually, the effects of faster spending on growth will disappear. All we get is permanently higher prices.
Sustainable economic progress comes from supply-side improvements. Better technology and laws are particularly important, since these effectively increase the resources at our disposal. Between 1980 and 2017, the number of man-hours it took to produce a ton of steel fell from 10.1 to 1.5. Better production methods massively increased the amount of output we could get with given inputs. That’s equivalent to increasing the labor supply, except that the additional production is shared by fewer people. Productivity growth is the only lasting way to produce rising output, and hence rising living standards.
But what happens to prices when output rises? Economic growth means more output. Comparatively less money chases comparatively more goods. All else equal, prices across the economy should fall. Economic growth is deflationary–or, at the very least, disinflationary.
We can see this by inspecting the dynamic equation of exchange: gM + gV = gP + gY, where gM is money supply growth, gV is velocity growth, gP is inflation, and gY is real output growth. The dynamic equation of exchange reminds us that the growth rate of effective money expenditure (gM + gV) equals the growth rate in dollar-valued output (gP + gY).
Suppose technological improvements boost economic growth, permanently increasing gY. The equation of exchange must still balance. Since the growth rates of the money supply and velocity haven’t changed, the only possibility is for inflation to fall. For every percentage point faster the economy grows, inflation falls by a percentage point.
The pundits have it backwards: Boosting growth by deregulating and promoting investment reduces inflation. This doesn’t mean faster growth is a cure-all. It would be impressive if we could eke out even half a percent more growth. A full percent would be stupendous. That wouldn’t help much if inflation were very high, as it was during the summer of 2022. But it would be great for living standards nonetheless.
Inflationary growth belongs in the waste basket of intellectual history, right next to the Phillips curve. That so many self-described experts subscribe to it is a serious indictment of experts as a class. If they can’t even get the basics right, why should we trust them?