Below is an extract from a commentary originally posted at www.speculative-investor.com on 9th November 2006.

In our 6th November commentary we made an effort to debunk the conventional wisdom that stronger economic growth leads to a rise in the general price level. Based on the feedback/questions received from several subscribers it is, we think, worth providing some additional explanation on this important topic.

If you spend even a small amount of time each day reading the mainstream financial press you could easily come away with the impression that there is a positive correlation between growth and prices. It is often not expressed exactly as "growth causes higher prices", but is, instead, portrayed in terms of a supposed trade-off between economic growth and inflation (with inflation, here, meaning a rise in the general price level). For example, on Monday 6th November Michael Moskow, President of the Federal Reserve Bank of Chicago, was quoted as saying: "The risk of inflation remaining too high is greater than the risk of growth being too low, thus some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability..." Then, on Tuesday, the Financial Times quoted Federal Reserve Bank of Richmond President Jeffrey Lacker as saying that the central bank had not been clear enough regarding "how it would respond to the pass-through of energy cost increases to consumers in the shape of higher prices", and that "...there is now a bigger risk of rising inflation than of slower growth...".

Both Moskow and Lacker reinforced the notion that there is some sort of trade-off between economic growth and inflationary pressures. Lacker also dragged out another piece of well-worn propaganda when he talked about higher prices for energy potentially causing prices to rise throughout the economy, but unsurprisingly failed to mention that in the absence of an increase in the total supply of money a price rise in one area of the economy (the energy sector in this case) would have to be offset by a price fall somewhere else.

As noted in our 6th November commentary, a Federal Reserve official has an excuse for spreading misinformation because doing so is a major part of his/her job description. Unfortunately, however, the vast majority of 'independent' analysts also toe the official line, proving once again that if a lie is repeated often enough then most people will come to embrace it as the truth.

Economic growth is the production of more goods and services, so it should be intuitively obvious that unless the money used within the economy is somehow being devalued then economic growth will generally lead to LOWER, not higher, prices. Or, putting it another way: it should be intuitively obvious that unless there is a change in the value of money then economic growth will result in the same money chasing a greater supply of goods and services, with the result being DOWNWARD pressure on the general price level. In determining the true reasons behind an economy-wide rise in prices the overriding focus must therefore be on the things that alter the value of money, chief among these being changes in the money supply and, by extension, the central bank. However, when was the last time you heard a central banker take responsibility for a drop in the currency's purchasing power?

The inverse relationship between economic growth and the general price level can even be seen in the famous "Monetary Exchange Equation". This equation is of almost no value for a number of reasons*, but it does, at least, demonstrate the aforementioned relationship. To be specific, the equation can be expressed as: Real GDP x GDP Price Deflator = Money Supply x Money Velocity; or GDP Price Deflator = (Money Supply x Money Velocity)/Real GDP. In other words, the monetary exchange equation shows that for a given monetary situation a rise in real GDP will be accompanied by a fall in the GDP price deflator (the GDP price deflator is a measure of how much of the economy's nominal output growth has been due to higher prices).

Also of note, the theory that there should be an inverse correlation between the rate of real economic growth and the rate of increase in the general price level is backed-up by empirical data. Now, we will take good logic over statistics any day because statistics can be manipulated to show just about anything. In particular, the statistics produced by governments are routinely manipulated to paint an inaccurate picture. But having said that, the following charts show that during the 1970s there was, in fact, a strong inverse relationship between the year-over-year growth rate in the US CPI (the red line on the top chart) and the year-over-year growth rate in real GDP (the red line on the bottom chart). Since 1980 there has not been a consistent correlation -- either positive or negative -- between the rate of GDP increase and the rate of CPI increase, but this is probably because the US Government has, over the past 25 years, made major changes to the way the CPI is calculated. These major changes, which began in 1982 with the removal of house prices from the CPI calculation, have greatly distorted the CPI's message.

Note that the shaded areas on the following charts identify the periods in which the US economy was officially in recession.

As outlined above, basic logic and the historical record both suggest that higher economic growth should be associated with less upward pressure on prices. So why, then, is the idea that there is some sort of trade-off between economic growth and worrisome pricing pressures so widely accepted?

One reason is the many decades of propaganda designed to blur the link between cause (increases in the supply of money) and effect (higher prices). Another reason is that people have been conditioned to believe the flawed Keynesian notion that economic growth is driven by consumption.

If real growth were driven by increasing consumption then it might be possible to make the case that both the money supply and the general price level could be pushed upward by increasing aggregate demand. However, it should be obvious that in order for someone to consume more they must first either produce more or dip into their savings (savings being former production that has been stored in some way). Alternatively, they could choose to borrow the money needed to satiate their desire to consume more, but in this case the lender of the money must have first produced in order to facilitate the borrower's desire to increase his/her consumption.

The point is that an increase in consumption must be preceded by (funded by) an increase in production in order for SUSTAINABLE economic growth to occur. That is, sustainable (real) economic growth is driven by increasing production.

There is, however, a way for consumption to precede production: via the creation of money 'out of thin air' by the banking system. Monetary stimulation of this type can create the illusion of buoyancy in the present (it can create an artificial boom), but it cannot bring about sustainable economic growth. It is, in effect, an attempt to get something for nothing that does long-term damage to the economy by distorting price signals.

*The main problem with the Monetary Exchange Equation is that the relationship between prices, money supply and real economic growth is determined by the daily decisions/choices of millions of people who each have their own motivations for doing what they do. This relationship is therefore way too complex and dynamic to be modeled by any mathematical equation, let alone a simple one-line equation. Another problem is the impossibility of determining a meaningful number that represents the average price level within the economy. For example, although it would be technically possible to calculate the average between the price of a new car, the price of a visit to the doctor and the price of a potato, such an average would be a totally meaningless number. A third problem is the use, in the equation, of the variable known as "money velocity". This variable cannot be measured and is really just a 'fudge factor' used to make both sides of the equation equal.