Understanding the Basics of Inflation
This will be an overview post, in a (probably futile) attempt to clear up confusion about inflation.
Two Definitions of Inflation
Price inflation - a persistent increase in the general price level.
Monetary inflation - an increase or overissue of currency
You can still find inflation defined in the second way (monetary) in college dictionaries in the 1940's. That's the traditional definition:
Inflation is an "expansion or extension beyond natural or proper limits or so as to exceed normal or just value, spefically overissue of currency." Funk and Wagnalls Standard College Dictionary (1941)
I can't explain how or why the definition changed. I can speculate but I won't. I will just point out that from the 1300's (at least) up until the 1940's, it was understood that overissue of currency caused price increases. Not even JM Keynes disputed this, as we will see below. The modern definition leaves the cause unknown. So it's not nearly as helpful.
Inflation is a policy
We'll get to the reason inflation is bad in a moment. Now that we understand what inflation is we will indicate the kind we are talking about as follows: (price) inflation and (monetary) inflation.
(Monetary) inflation is a policy. It is encouraged because it is believed that it encourages economic growth. We do not dispute that (monetary) inflation increases economic activity.
Market Money and Fiat Money
Market money, such as the gold standard, operates differently than fiat money. The classical gold standard was not a government central planning project. Government's only role was to leave it alone, which it turned out was too much to ask. With market money, demand for money drives the increase in money production. In other words, as money becomes more valuable (and hence, prices fall), production of money increases to meet demand (and therefore, prices rise.) This is a built in balancing activity. Fiat money is not created because of a demand for money. More often than not, fiat money is created to pay for wars, pay for political promises, and stimulate economic activity.
How (monetary) inflation works
When new money enters the economy, the person (s) who uses it first gains a benefit. Let's look at it on a timeline. This has to be a rough sketch and I'm doing this roughly from memory so don't be too harsh. This is the basic outline of how money works its way through an economy:
T=0 - At this point, no money has been created. Prices are at X level.
T=1 - New money is created. Prices still at X level
T=2 - New money is givng to person (s). Prices still at X level. (The person(s) may be government, banks, government contractors, etc.)
T=3 - The money is spent in the market economy. Prices still at X level. Those who finally do spend this money get a benefit (if they don't spend it, they receive no benefit). They spend the money before it causes (price) inflation, at X price level. Governments are typically the first to spend money (in a pure fiat system, they are the only ones who get to spend it first.) This is how government's growth becomes unstoppable.
T=4 - Those who exchanged goods/services for the new money are now flush with cash. They, in turn, begin to replace their stock (and may increase it to meet a perceived rise in demand). Prices are still at X level.
(At this point it is important to remmeber that resources are scarce and that this is an economic fact of life).
T=5 As the people who recieved the money in exchange for their goods start to work it through the economy, that money competes with existing currency to bid on economic resources. This drives up the cost of those resources. Prices start to rise above X level.
T=6 Producers and businesses start to experience higher costs and must raise their prices to offset falling profits. Prices rise further.
T=7 Laborers experience a rise in the cost of living. By the time newly created money reaches them, prices have risen above the level that our first "spenders" at T=3 enjoyed. Workers are at an economic disadvantage. They must raise the price they are willing to accept for their labor. This in turn increases business costs. Prices rise further. Look what JM Keynes had to say about this effect:
"[A] demand on the part of the trade unions for an increase in money rates of wages to compensate for every increase in his cost of living is futile, and greatly to the disadvantage of the working class. Like the dog in the fable, they lose the substance in grasping at the shadow. It is true that the better organised might benefit at the expense of other consumers. But except as an effort at group selfishness, as a means of hustling someone else out of the queue, it is a mug's game …" - JM Keynes, How to Pay for the War (London: Macmillan, 1940)
In other words, the better organized may be able to keep their wages up with the cost of living, but in order to do so, it will be at the detriment of everyone else (consumers, non-union workers). In the end, the unions will be perpetually chasing a higher cost of living. Chasing inflation is a mug's game.
T=8 People on fixed incomes typically get the money last. They suffer the most. By the time their incomes are "adjusted for (price) inflation", everyone else has already touched the previously created money. At this point the competition for money has driven up nearly all costs so that when they finally spend it, they suffer an economic detriment.
T=9 Lather, rinse, repeat.
Here are the key points about (monetary) inflation:
1. The person(s) who spends first gains. The person(s) who spends last loses.
2. Government growth is inevitable and inescapable under pure fiat currency. There is absolutely NOTHING you can do to stop it. Talks of budget cuts are totally meaningless when the government can create and spend money before you can.
3. In the short run, prices can rise for a number of reasons (and you can list all the mainstream explanations like demand shock and bad weather here, and they would apply). In the long run, prices rise due to (monetary) inflation. This is irrefutable.
4. In a market economy, wealth is created by increasing productivity. Not by printing dollar bills. The fact that we are all wealthier today is in spite of inflation, not because of it.
A Second Look at (Monetary) Inflation
Besides the problems listed above, there is a more serious charge against (monetary) inflation called the Austrian Theory of the Business Cycle.
This theory, attributed to Hayek but also the product of the work of Menger, Bohm-Bawerk, von Mises, and Rothbard, states that artifically low interest rates cause an unsustainable economic boom.
Let's look at a brief sketch. You can research ABCT more thoroughly with the links provided:
1. Artificially low interest rates increase the amount of borowing (and hence, indebtedness) particulary among producers in higher order goods (Housing is a higher-order good.)
2. An increase in loanable funds must meet this increase in demand caused by artificially low rates. The money supply starts to expand as fractional reserve banks work their magic. This is (monetary) inflation. (Notice that the demand for money is not caused by the market, but rather by a central planner who manipulated interest rates.)
3. Economic activity increases. People feel wealthier than they really are. Furthermore, investment in new projects does not match consumer time preference. Consumer time preference is indicated by their rate of saving. Since consumers are not saving at all (or very little) thanks to artificially low interest rates, they have a very short time preference.
4. Projects started in higher-order goods industries are destined for bankruptcy. Consumers are not saving at a rate to justify expansion in higher-order goods.
5. The bidding for resources drives up the costs of production, starting a wave of bankruptcies.
6. Everyone gets bailed out. The free market is blamed. We start over again. =D
(Every boom in history can be traced to a expansion of loanable funds, even the Tulip Bubble.)
Austrian Business Cycle Theory: A Brief Explanation
Either way you look at it, as (price) inflation or (monetary) inflation, something isn't right. Does that mean if you study inflation, you are Nancy Negative? No. It's one facet of our world. Last night at work I got into a running six hour argument with my co-worker over who would be a better senior engineer on our shift, Jesus, Superman, or Colonel Nathan R. Jessup from A Few Good Men? We both decided we'd rather hire the Sham-Wow Guy for comedic effect. Yeah, I'm such a serious guy.
But when I look at the criticisms leveled against negativity, I'm flabbergasted by how little these people actually understand about the views they are criticising.
This is just a taste. There are more interesting things that can be said about inflation, but I don't have the time. I barely touched on fractional reserve banking, wars, central planning, or public deficits or the history of these schemes. All of these are features of an inflationary regime.
For more, please check out this previous blog:
Inflation: What is it good for?
For the historically inclined:
A HIstory of Inflation in Rome
John Law and the Invention of Modern Finance
David in Qatar