A U.S. dollar in 2011 has lost 95.9 percent of the buying power it had a century ago. In other words, the Consumer Price Index is 24.3 times as high in 2011 as it was in 1911. Michele Bachmann says that is bad. In a recent speech, she asserted, “A dollar in 2011 should be the same as a dollar in 1911.”
Many Americans might agree with the Minnesota congresswoman and presidential candidate. But would we necessarily be better off if a dollar could buy exactly as much now as a century ago? The answer is more complicated than some might think.
First, let’s understand what we mean by “the value of the dollar.” When economists use this term, they commonly mean what a dollar will purchase in goods and services within the United States as measured by a price index such as the Consumer Price Index or the GDP Deflator. They would use the term “exchange value of the dollar” in referring to the ability of the dollar to buy the currencies of other nations.
In the same speech last week, Bachmann said, “In the last two years of the Obama administration, if you pull a dollar out of your pocket, you have lost 14 percent of the value of that dollar.” That is flat-out wrong. The CPI for May, the last available, stands 5.7 percent above where it was in May 2009. However, it is only 2.7 percent above where it was in the summer of 2008, when commodity prices were also spiking.
If Bachmann was confusing the domestic purchasing power of the dollar with its foreign exchange value, she still is wrong. The dollar does purchase about 2.5 percent fewer euros than in July 2009, not 14 percent, as Bachmann said, and 6.4 percent fewer than when Obama was inaugurated in January 2009. However, the dollar actually buys 9.2 percent more euros than it did three years ago, before Obama took office.
In criticizing Obama, she ignores the fact that the value of the dollar is driven largely by actions of the Federal Reserve, for which the key policy-makers were dominated by George W. Bush appointees until quite recently.
However, the underlying problem for Bachmann, her fellow candidate Ron Paul, and many others, is that they are confused by what Josef Schumpeter called “the veil of money.” People use real resources such as labor, land and tools to produce goods and services to meet their needs and wants. This is the real economy. Money is only a tool to facilitate that process. But people’s tendency to focus on what is immediately visible – money – obscures their understanding of the far more important underlying real economy of resources, goods and services.
The relevant measure of whether people are better off in 2011 compared with 1911 is how much better they are able to meet their physical and psychological needs, not the value of a dollar measured by the CPI.
Wages as well as prices vary with inflation. Someone earning $40,000 might think “Gosh, if prices had not gone up 28 percent in the last decade, think of all the things I could afford.” This is what economists call “money illusion.” If prices had not gone up by that degree she very likely would not be earning $40,000. The question is whether most people can buy more with their incomes today than they could in 2001.
But what if, as Rep. Bachmann suggests, there had been zero inflation between 1911 and 2011? Would the real economy – the amount of goods and services available to meet people’s needs – be larger or smaller than it is today? The answer to that is unknown.
The tripling of the CPI in “the Great Inflation” from 1967 to 1982 certainly reduced real economic growth. But the 24 percent decrease in prices between 1929 and 1933 was associated with far greater loss of output and far greater human suffering.
The Fed tolerated inflation during the World Wars, with prices doubling from 1914 to 1920 and increasing by 61 percent from 1939 to 1947, when wartime price controls were removed. Would we be more prosperous if the Fed had followed such tight monetary policies that prices had remained fixed? Would we have won these wars with less loss of life or treasure?
Economists are nearly unanimous that stable prices are better than high inflation or high deflation. They do not agree exactly what constitutes “stable prices.” For a variety of reasons, most would say that moderate inflation – 1 to 2 percent – is no worse than zero inflation and better than 1 to 2 percent deflation. Yes, 2 percent annual deflation will cut the purchasing power of money by 86 percent after a century. But if we have more real goods and services after that century than we would have had with the fixed value of a currency Bachmann and Paul advocate, we are better off.
© 2011 Edward Lotterman
Chanarambie Consulting, Inc.