"Inflation is Always and Everywhere a Monetary Phenomenon" is > The Fallacy of Composition (6 min read)

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs follows up in detail on CO’s excellent post regarding Trump’s proposed tariffs with his own explaining how good economists have known for centuries tariffs are not inflationary, no matter how hard the press tries to frame them that way.

Photo: British economist David Ricardo understood in 1801 what Janet Yellen and the media still don't get in 2025.

Last week CO ran a short post explaining that tariffs don’t cause inflation unless the money supply is expanded alongside them. The week before he ran a post criticizing Janet Yellen for blaming “COVID supply chain bottlenecks” for the last four years’ inflation, rightfully rebutting that:

“If that were true prices would be back down already. Sorry, try again.”

The Economics Correspondent wants to revisit another, even more popularly cited excuse for inflation: higher energy prices.

All of these scapegoats for inflation—supply chain bottlenecks, oil prices, and tariffs—originate from the same economic fallacy. Although the scapegoats sound good to those uninitiated to monetary theory, the logical error was smoked out at least two centuries ago for being rooted in the “fallacy of composition.”

We’ll explain the fallacy of composition as it relates to money in this column, but for the moment let’s go back to high energy prices.

OIL

During the worst period of our recent inflation—fall 2021 to summer 2023—we heard endless blame heaped on “high energy prices” from the White House, from Democratic politicians, from the mainstream media, from the business press, and from (some) academic economists.

The excuse making went something like this:

”Higher oil prices (aka. ’Putin’s war’) and the evil Sith lords of Big Oil have caused this inflation for consumers. Oil is an input in just about every sector of the economy: shipping, distribution, transportation. When energy prices go up, the higher prices force manufacturers, wholesalers, retailers, etc. to pass the cost on to consumers by hiking their own prices, and you get inflation.”

Again, this is an ancient fallacy which was discredited at least as early as 1801 by British classical economist David Ricardo. But in the early 2020’s the constant repetition of the same fallacy remains parroted by left-leaning liberals and even some conservatives were citing it, understandable since the inflation apologists control the media.

The Correspondent wishes to dispel, once again, the fallacy with both empirical evidence and theory.

The easiest empirical evidence lies in today’s oil prices: they’re 40% lower than the 2022 peak. In fact the current price per barrel is hovering near summer of 2021 and the summer of 2018 levels. 

So if higher gas prices were really the culprit behind inflation in 2022 and 2023, and gas prices have since fallen back to summer of 2021 levels, then inflation must have reversed itself and consumer prices fallen back to 2021 levels as well.

Have they? 

How many people in CO Nation can say they’re paying the same amount of money to live today as they were in July of 2021?

Even the St. Louis Federal Reserve, using conservative government figures, says today’s consumer price index is 17% higher since June of 2021.

So much for higher energy prices being the culprit—at least empirically.

Higher energy prices were also blamed by politicians, intellectuals, and most of the press during the inflation era of the 1970’s, especially right after the OPEC oil embargo that began in 1973.

Well, oil prices did rise sharply—from $11.65 per barrel at end of 1973 to $35 in 1980, effectively tripling—and there was no shortage of politicians and compliant journalists blaming the 1970’s inflation on OPEC.

But by 1986 oil had crashed back down to $10, even less than in 1973. 

So did the cost of living also fall back down to 1973 levels?

Nope. According to the Fed the 1986 consumer price index was 139% higher than 1973. That’s right, even after oil prices plummeted by 72% overall consumer prices had still more than doubled, not fallen as the energy “cost push” theory predicts.

Meanwhile in an incredible coincidence (sarcasm) the money supply measured by M2 was ballooned by 221% from 1973 to 1986: from $849 billion to $2.73 trillion. 

Now we’re getting somewhere.

THEORY

To understand why higher input costs don’t create inflation one has to go back to the seminal “equation of exchange” that defines the relationship of real economic factors to prices.

In nerdy math the formula is mv = py where m = money supply, v = monetary velocity, p = price level, and y = total real output.

But in plain English, only three factors move the general price level: the money supply, output of goods and services, and velocity of money.

Note that nowhere in this formula is there a variable for “higher oil prices,” nor is there one called “corporate greed.”

British financier and economist David Ricardo was the first to associate money, output, and velocity to prices, and he too was confronted with an early 19th century version of the same "cost push” inflation fallacy during the Napoleonic Wars.

From 1797 to 1821, during which time Britain was usually at war with Revolutionary and Napoleonic France, Parliament suspended the gold standard and the Bank of England printed lots of new paper money to finance the conflict. By 1801 prices were rising everywhere. 

Britain had also suffered from two bad wheat harvests prompting a group of businessmen, dubbed the “antibullionists,” to blame high wheat prices for causing general inflation. 

The logic, just like with Joe Biden and oil, was that wheat was a major food staple and input in most people’s lives which in turn pushed up their living costs which in turn pushed up their wages which in turn pushed up prices on everything.

Once again, the classic “cost push” theory that we hear today.

But Ricardo and fellow economist Henry Thornton, leaders of the dissenting group dubbed the “bullionists,” rejected this explanation.

Why?

Well for once the Correspondent would like to let someone else explain: of all people, the Federal Reserve (yes, that Federal Reserve).

From an excellent 1998 Fed paper titled “Historical Origins of the Cost-Push Fallacy”:

”Led by quantity theorists David Ricardo, John Wheatley, and Henry Thornton, one group of economists, the bullionists, blamed the Bank of England for creating inflation through excessive issues of paper notes. The Bank, they said, had simply taken advantage of the suspension of convertibility to generate an inflationary overissue of the currency. Seeking to correct this state of affairs, they recommended that England return to gold convertibility at the prewar parity as soon as possible.”

And their destractors resisted:

”An opposing group of practical businessmen and bankers, known collectively as the antibullionists, rejected this monetary explanation. Instead, they attributed the price rises to such real shocks as domestic crop failures… …they highlighted cost-push influences directly affecting the individual prices of specific commodities, notably grains and other staple foodstuffs that constituted the principal component of workers budgets. These food-price increases then passed through into money wages to raise the price of all goods produced by labor.”

Again, the classic “cost push” theory, which brings us to the crux of the decisive argument:

“This notion, however, hardly went unchallenged. Bullionist writers, especially David Ricardo, criticized it for confusing relative with absolute prices. Ricardo contended that, in the absence of inflationary monetary growth, aggregate nominal demand, as measured by velocity-augmented money MV, would remain unchanged. With total spending (and full-capacity aggregate output) fixed, a rise in the relative price of food requiring workers to spend more on that commodity would leave them with less to spend on other goods whose prices would accordingly fall. If so, then the rise in food’s price would be offset by compensating falls in other relative prices, leaving general prices unchanged.”

That is the monetary fallacy of composition: believing that the rise in price of one commodity drives a rise in prices of everything else, when in reality some goods can rise in price while the resulting lower monetary demand for other goods allows them simultaneously to fall in price—but ONLY if the central bank doesn’t print more money.

The same is true for energy prices in 2022. If companies were forced to pay more for energy, they would have less money leftover to pay for other goods whose prices would correspondingly fall… but ONLY if the central bank didn't expand the money supply.

And we all know the Fed didn't hold back from expanding the money supply. From the outbreak of Covid to the summer of 2023, the U.S. money supply measured by M2 rose from $15.45 trillion to $20.76 trillion, a stunning 34.4% increase.

And here, once again as is always is the case, is our culprit for inflation: Fed-induced growth of the money supply.

To wrap up why some economic myths never die, our Fed paper concludes:

”With these arguments, the bullionists exposed the logical flaws inherent in each component of antibullionist cost-push theory… … Nevertheless, they proved impossible to kill. Though flawed, they possessed the advantage of being at once simple, transparent, intuitively appealing, and consistent with the everyday experience of practical businessmen. Illustrating the adage that popular economic theories (no matter how fallacious) never die, they survived to flourish in subsequent monetary debates.”

Wow the Fed (or more accurately one of its contributing writers) got something right!

And here we are in 2025 where governments, who love inflation, and their allies in media and academia are more than happy to keep propagating both the “cost-push fallacy” and “fallacy of composition.”

In the 224 years since David Ricardo first criticized the theory a long list of distinguished economists has repeated his absolutely correct position: from Knut Wicksell to Irving Fisher to Friedrich Hayek, and—most recognizably for Americans—Milton Friedman who famously summated: “Inflation is everywhere and always a monetary phenomenon.”

The excellent and very Friedman-esque Fed paper can be read in full at:

https://www.richmondfed.org/-/media/richmondfedorg/publications/research/economic_quarterly/1998/summer/pdf/humphrey.pdf