Myth of the Price Level
A popular view advocates that the Fed should manage the economy so as to keep inflation in check, while also being on guard against deflation. In this view, prices must not rise too much or fall too much, but rather stay within some happy median. To borrow an oft-used expression, the ideal is seen as sort of a 'Goldilocks economy'—not too hot and not too cold but just right.
In this camp, for example, it is today common to propose that the Fed reinflate the economy by lowering rates and pumping money into the economy—the economic charlatan's sugary medicine for better economic health (it has usually been politically easier to swallow rate cuts and an expanding money supply than to do nothing in the face of economic turbulence). It would seem that this idea animated Greenspan's recent cuts in the fed funds target rate. Such moves, it is also commonly believed, will stave off deflation (which is popularly viewed as an illness) and will help the economy grow again.
Like many popular ideas, the idea that the Fed (or anyone) should manage prices sounds much better than it is. Under closer scrutiny, the whole concept reveals gaping fissures of economic error. Attempting to manage prices on some aggregate level misses some core economic truths.
As Austrians have long appreciated, prices do not move all in sync in response to changes in money supply. Prices respond to the forces of supply and demand for that particular product or service, and prices are also impacted by changes in the demand for and supply of money. Separating these forces by looking at prices is necessarily qualitative, conjectural and complex.
But since money is not "gifted" to everyone at the same time and is not spent in exactly the same way, it should be obvious that prices will not respond in some unified manner. Prices behave not like a professional Broadway dance company, but more like a class of ornery four-year olds short on naps—they can move unpredictably and in all different directions.
One cannot look at monetary conditions only and predict some relation for future price changes, nor can one extract some mythical price level to manipulate in a formulaic manner. As Ludwig von Mises repeatedly taught over his long career, money itself is a dynamic agent: "What is fundamental to economic theory is that there is no constant relation between changes in the quantity of money and in prices. Changes in the supply of money affect individual prices and wages in different ways. The metaphor of the term price level is misleading."
This seems like such a simple observation, so intuitively appealing, that it is hard to believe that anyone would care to refute it. However, implicit in any attempt to manage prices is the belief in the idea of a "price level".
Murray Rothbard, too, noted the fallacy of the price level concept, "This contention rests on the myth that some sort of general purchasing power of money or some sort of price level exists on a plane apart from specific prices in specific transactions." Prices have meaning only in the context of specific transactions.
Prices in a market economy form a complex constellation of billions of points, all moving, all responding to numerous forces acting upon them. Take a snapshot at any point in time and it will be just that—a snapshot of a dynamic environment. "The prices of the market are historical facts expressive of a state of affairs that prevailed at a definite instant of the irreversible historical process," Mises noted. In the world of economics, "in the praxeological orbit," to use Mises's phrase, "the concept of measurement does not make any sense." That is part of the mystery and charm of markets, and why the study of them is a distinctive field, very different from the quantitative fields of physics and mathematics.
To speak about average prices is like talking about average precipitation to a golfer. It either rains during a specific time period or it doesn't. There is no average that is in anyway useful for an acting human being on a golf course. The only information that counts is what it is doing right now while he is teeing off. It is the same with prices.
Business people do not operate in a world of index numbers. They exist in a world of specific prices for specific goods and services. As Mises observed, "In practical life nobody lets himself be fooled by index numbers." Therefore, arguments that unstable CPI or PPI numbers make it somehow more difficult for business are erroneous.
Also implicit in the notion that prices should be managed in some way is the idea that stability, i.e., a lack change or minimal change, is automatically better than changes of a larger magnitude. As Mises keenly observed, "It is a general weakness of the human mind to regard the state of rest and absence of change as more perfect than the state of motion."
Prices will change and should change given all the forces acting upon them—the push and pull of consumer demand on the good itself and wider changes in the valuation of the currency, also being pushed and pulled by consumers' actions. To advocate prices that change within only some arbitrary band begs the question of who should decide how much prices should move? And why do they decide and not the consumers?
Advocating prices that fluctuate less than free market prices means, in essence, that you are trying to block the efforts of consumers. By attempting to reign in price changes you are preventing people from achieving their goals. For example, an attempt to prop up the value of the dollar in the face of market-born weakness prevents people from reducing their real cash holdings.
To state the obvious: The economy does not exist to satisfy statisticians. Nor does the economy itself have any self-interest. So, it is nonsensical to talk about the health of the economy as if it was a person walking around with needs and wants.
You hear this kind of thing all the time however. Someone will write what is good for the individual is bad for the economy. For example, if everyone decided to increase savings by some amount, many economists feel this would put the economy into recession and that it is a bad thing. Well, how can that be?
Obviously, the person saving the money is satisfying some want or need. Therefore, if everyone is increasing savings, then they are fulfilling wants and needs. The fact that the economy goes into recession is a consequence of their actions, but the primary effect of the recession is corrective, i.e. to put the economy back on a path supported by consumers. It cannot be good for all the individuals and bad for the economy.
That is not to say that all market outcomes will be beneficial for all people. For example, most people feel like they should be paid more for what they do. However, what one can earn varies by profession, by location, among many other factors—many well outside of one's control. Intuitively, one understands the weakness of an aggregate wage level, weaknesses that are similar to aggregate price levels as well.
So by watching aggregate price indices and attempting to confine changes within some arbitrary range one is making some very fallacious assumptions. The effect of all this is really to create economic disorder and chaos. As Austrian business cycle theory teaches, the boom and bust phenomenon is created by the interventions of governments.
The goal, then, should not be to manage prices. The goal should be to ensure that prices are free to fluctuate. Therefore, an emphasis should be placed not on containing prices, but on eliminating obstacles that attempt to change prices to something other than what is supported in the market place.