Money Part III - Inflation... Whoo! Haa! What is it good for?... Definitely Something!
In my first two posts on Money we've covered a lot of ground. I've learned a lot from the commentors. I hope a few readers have a learned a little from me. Today the discussion turns to Inflation. After quickly covering the basics, I hope to show that Inflation has a purpose and to clearly demonstrate how it benefits some people at the expense of others, particularly the poor and middle class. Here's a review of where we are:
Part 1 - We talked about the history of money, how money comes into use naturally, why market participants have always chosen the natural monies, and why government has outlawed natural money use with "legal tender" laws.
Part 2 - Property rights were discussed after showing that fiat paper money are property rights can not co-exist. The doctrines of Catholic and Protestant churches were presented to make the Christian case that Property Rights are sacred, and thus, fiat money is unethical from a Christian perspective.
We need to start by coming to an agreed upon definition for inflation. The modern definition is a persistent rise in prices. Traditionally, however, inflation has been defined as an expansion of the monetary base beyond what the market would normally support. Why has the definition changed? I don't know. Why has the definition of Liberalism changed to mean Moderate Socialist? Agnosticism of meaning, I suppose. That has a purpose too, but it's not what we are here to discuss.
Inflation is an "expansion or extension beyond natural or proper limits or so as to exceed normal or just value, spefically overissue or currency." Funk and Wagnalls Standard College Dictionary (1941)
In that view a persistent rise in prices is the result of inflation. Either definition is fine, as long as its meaning is generally understand. Confusion is not something I wish to promote. For this blog, I could just as easily said "Money Part III - Monetary Base Expansion Past Market Limits" but then I couldn't have ripped off an Edwin Starr song.
Types of Inflation
There are many ways to bring about inflation. The common theme of each of these is that the person or organization perpetrating inflation benefits.
Counterfeiting: This is the act of passing off a coin or certificate as the same as one already in use. The practice has been with us since the beginning of time and is not likely to go away any time soon. In historically competitive money supply markets, counterfeits were discoverd quickly and their mere existence taught a valuable lesson to individuals that money should be safeguarded.
The bottom line: In terms of inflationary effects, it is quantitatively negligible.
Fractional Reserve Banking: The roots of today's banking system arise from the European money warehouses of the 1600s. Eventually the obligation to repay the bank note was changed to a promise to pay, a slight change of wording but a very important legal one. The owner of wealth was simply changed through a legal trick from the depositor to the banker. Money deposited in banks today continue that legal tradition, and as such are seen by the government as being owned by the bank. There are many theories as to way fractional reserve banking came about. Some believe that it was simply greed, while others point to government intervention. Another theory suggests that money warehouse owners were protecting themselves from the robbery of kings and princes. Any way you slice it, fractional reserve banking is unethical and serves the interests of the banks and governemnts while perniciously robbing wealth from everyone else through the loss of purchasing power (PPM) and complete loss of wealth in a bank panic. The FDIC, rather than stemming the tide of bank closings, has merely transferred the loss of wealth over a wider population, thus reducing the political consequences, rather than the monetary consequences.
The bottom line: Fractional Reserve Banking is a result of government intervention, particularly price controls set by European kings regarding the exchange rates of various metals. Businessmen accepted bank notes as a last resort to protect themselves from bankruptcy, hoping that over time the various metals that were forced out of circulation due to Gresham's Law, would return.
Fiat Priviledge: And so enters the State into the profitable business of inflation. The name Nicole Oresme isn't mentioned in American classrooms very often. It was Oresme who wrote the first known treatise castigating the ruling class for willful debasement of the currency. (Treatise on the Alteration of Money, 1371).
"...it is exceedingly detestable and disgraceful in a prince to commit fraud, to debase his money, to call what is not gold, gold, and what is not a pound, a pound, and so forth.... Besides, it is his duty to condemn false coiners. How can he blush deep enough, if that be found in him which in another he ought to punish by a disgraceful death?"
Unfortunately, such debasement became institutionalized with the advent of fiat paper money. No longer are rulers disgraced when caught purposefully manipulating their currency. Rather, they march out an army of economists (all of whom owe their reputations to that very government) to cheerlead the masses by extolling the virtues of such unethical practices.
There are two direct benefits that can be discerned by paper money inflation. First, the government can repay debts contracted more cheaply. If the government forces its creditors to collect in only the money issued by government, it is in the government's best interest to inflate its own currency as much as politically possible. There is no monetary limits to the level of inlation the government can bring about to monetize its debt. It is important to remember that the ruling class works outside of the competitive market, and therefore, has no rational pricing mechanism.The second benefit of inflationary policy is best understood by the Cantillon effect.
The Cantillon Effect
"I am of the opinion that the main and final cause why the prince pretends to the power of altering the coinage is the profit or gain which he can get from it; it would otherwise be vain to make so many and so great changes.... Besides, the amount of the prince's profit is necessarily that of the community's loss." Nicole Oresme
Each new money unit benefits the first recipient. As the new money enters the market, its effects are not felt all at once, but rather in steps. The initial benefactors get to use it while its PPM remains at old levels, as the purchasing power was before the introduction of the new money. As it gets spent through the system, its PPM drops along with that of the older currency. It is the consumers, on average the poor and middle class, who upon purchasing the finished products suffer the greatest as their purchases are made when the currency's PPM is at its lowest. Therefore, any theory that pretends to social justice can not also ignore the effects that government spending has on the very people they are offering to assist. This phenomenon is known more precisely to Austrian School economists as The Inflation Tax. It is an indirect, and particularly clever tax that is rarely considered by even the most astute private citizens.
The bottom line: Fiat inflation is a policy that is pursued as vigorously as politically possible by the ruling class, and has been so since the dawn of fiat priviledge. It is pursued to further the interests of government at the expense of private citizens and has led to unprecedented expansion of government power and intervention in our economic affairs.
Effect of Inflation on the Market: The Business Cycle
Along with Mises' work on the Socialist Calculation Problem, the Austrian Theory of the Business Cycle is among the Austrian School's most significant contributions to the field of economics.
"Which of you wishing to construct a tower does not first sit down and calculate the cost to see if there is enough for its completion? Otherwise, after laying the foundation and finding himself unable to finish the work the onlookers should laugh at him and say, 'This one began to build but did not have the resources to finish." - Jesus Christ as quoted in Luke 14: 28-30
Inflation creates false savings. Instead of real savings through capital accumulation, inflation deceives the populace into thinking that it has produced more than it has, saved more than it has, and has more capital to invest than it has. The result is a boom cycle littered with shady and speculative investments, each more profitable than the last, leading to ever more wild speculation. If the inflationary effects are truly massive an entire culture of consumption, spending, and reckless investment can set in. Resources are diverted away from their most productive uses into businesses and financial instruments that would not warrant expansion or investment in a free market.
Now it is true that booms and busts have happened before the Federal Reserve Act of 1913. Those inflationary booms, all brought upon by fractional reserve inflation, and their subsequent busts were extremely mild compared to The Great Depression. That depression was a predictable consequence of the Fed's inflationary policies of the 1920s, just as this depression is a predictable consequence of the Fed's inflationary policies of the 1990s.
Getting back to the biblical quote above, the entrepreneur in an inflationary environment becomes the fool laughed at by the onlookers. He/she places capital in an investment that can not be finished. The family buys a home in an asset bubble, unaware that prices are rising due to monetary expansion, as brokers, bankers, and politicians assure them that prices will rise forever. The investor picks stocks, unaware that the entire landscape of investment is built upon an untenable expansion of paper money, excess credit, and shady speculation. When the bust happens, the astute economist foretelling the inevitable is drowned out in a sea of shouting government economists, political hacks, and ignorant attention-seekers decrying the free market. How bizarre, indeed!
The bottom line: There is no practical or ethical case one can make for the policy of inflation, or for that matter, fiat paper money. As we will see in Part 4, however, many have made very eloquent defenses of this system. We will examine those more closely next.
"Woe to those who call good evil, and evil good." - Isaiah 5:20
David in Qatar