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There is almost complete unanimity
among economists and various commentators that inflation is about general
increases in the prices of goods and services. From this it is established
that anything that contributes to price increases sets in motion inflation. A
fall in unemployment or a rise in economic activity is seen as a potential
inflationary trigger. Some other triggers, such as rises in commodity prices
or workers' wages, are also regarded as potential threats.
If inflation is just a general rise
in prices as the popular thinking has it, then why is it regarded as bad
news? What kind of damage does it do?
Mainstream economists maintain that
inflation causes speculative buying, which generates waste. Inflation, it is
maintained, also erodes the real incomes of pensioners and low-income earners
and causes a misallocation of resources. Inflation, it is argued, also
undermines real economic growth.
Why should a general rise in prices
hurt some groups of people and not others? Or how does inflation lead to the
misallocation of resources? Why should a general rise in prices weaken real
economic growth? Also, if inflation is triggered by various factors such as
unemployment or economic activity then surely it is just a symptom and
therefore doesn't cause anything as such.
To ascertain what inflation is all
about, we have to establish its definition. Now, to establish the definition
of inflation we have to establish how this phenomenon emerged. We have to
trace it back to its historical origin.
The Essence of
Inflation
Inflation originated when a
country's ruler, such as a king, would force his citizens to give him all
their gold coins under the pretext that a new gold coin was going to replace
the old one. In the process, the king would falsify the content of the gold
coins by mixing it with some other metal and return diluted gold coins to the
citizens. On this Rothbard wrote,
More characteristically, the mint melted and recoined
all the coins of the realm, giving the subjects back the same number of
"pounds" or "marks," but of a lighter weight. The
leftover ounces of gold or silver were pocketed by the King and used to pay
his expenses.
Because of the dilution of the gold
coins, the ruler could now mint a greater number of coins and pocket for his
own use the extra coins minted. What was now passing as a pure gold coin was
in fact a diluted gold coin.
The increase in the number of coins
brought about by the dilution of gold coins is what inflation is all about.
As a result of the increase in the number of coins that masquerade as pure
gold coins, prices in terms of coins now go up (more coins are being
exchanged for a given amount of goods).
Note that what we have here is an
inflation of coins, i.e., an expansion of coins. As a result of inflation,
the ruler can engage in an exchange of nothing for something (he can engage
in an act of diverting resources from citizens to himself). Also note that
the increase in prices in terms of coins comes because of the coin inflation.
Observe however that it is the increase in coins brought about by the
dilution of gold coins that enables the diversion of resources here to the
ruler and not an increase in prices as such.
Under the gold standard, the
technique of abusing the medium of exchange became much more advanced through
the issuance of paper money unbacked by gold.
Inflation therefore means an increase in the number of receipts for gold because
of receipts that are not backed by gold yet masquerade as the true
representatives of money proper, gold.
The holder of unbacked
receipts can now engage in an exchange of nothing for something. As a result
of the increase in the number of receipts (inflation of receipts) we now also
have a general increase in prices. Observe that the increase in prices
develops here because of the increase in paper receipts that are not backed
up by gold. Also, what we have is a situation where the issuers of the unbacked paper receipts divert real goods to themselves
without making any contribution to the production of goods.
In the modern world, money proper
is no longer gold but rather paper money; inflation in this case is an
increase in the stock of paper money.
Observe that we don't say, as
monetarists are saying, that the increase in the money supply causes
inflation. What we are saying is that inflation is the increase in the
money supply.
Note that increases in the money
supply set in motion an exchange of nothing for something. They divert real
funding away from wealth generators toward the holders of the newly created
money. This is what sets in motion the misallocation of resources, not price
rises as such.
Real incomes of wealth generators
fall, not because of general rises in prices, but because of increases in the
money supply. When money is expanded, i.e., created "out of thin
air," the holders of the newly created money can divert goods to
themselves without making any contribution to the production of goods.
As a result, wealth generators who
have contributed to the production of goods discover that the purchasing
power of their money has fallen, because there are now fewer goods left in
the pool — they cannot fully exercise their claims over final goods,
because these goods are not there.
Once wealth generators have fewer
real resources at their disposal, this is obviously going to hurt the
formation of real wealth. As a result, real economic growth is going to come
under pressure.
General increases in prices, which
follow increases in money supply, only point to an erosion of real wealth.
Price increases by themselves however do not cause this erosion.
Likewise it is monetary inflation,
and not increases in prices, that erodes the real
incomes of pensioners and low-income earners. As a rule, they are the last
receivers of money, often called the "fixed-income groups."
According to Rothbard,
Particular sufferers will be those depending on fixed-money contracts
— contracts made in the days before the inflationary rise in prices.
Life insurance beneficiaries and annuitants, retired persons living off
pensions, landlords with long-term leases, bondholders and other creditors,
those holding cash, all will bear the brunt of the inflation. They will be
the ones who are "taxed."
Can Inflation
Emerge While Prices Stay Unchanged?
Now, all other things being equal,
if for a given stock of goods an increase in the money supply occurs, this
would mean that more money is going to be exchanged for a given stock of
goods. Obviously, then, the purchasing power of money is going to fall, i.e.,
the prices of goods are going to increase (more money per unit of a good). In
this case the general increase in prices is associated with inflation, i.e.,
increases in paper money.
But now consider the following
case: the rate of growth in money is in line with the rate of growth in
goods. Consequently, the prices of goods on average don't change. Do we have
inflation here or don't we? For most economists, if an increase in the money
supply is exactly matched by the increase in the production of goods, then
this is fine, because no increase in general prices has taken place and
therefore no inflation has emerged. We suggest that this way of thinking is
false: inflation has taken place, i.e., the money supply has
increased. This increase cannot be undone by the corresponding increase in
the production of goods and services.
For instance, once a king has
created more diluted gold coins that masquerade as pure gold coins he is now
able to exchange nothing for something irrespective of the rate of growth of
the production of goods. Regardless of what the production of goods is doing,
the king is now engaging in an exchange of nothing for something, i.e.,
diverting resources to himself by paying nothing in return. This diversion is
possible because of the increase in the number of coins brought about by the
dilution of gold coins, i.e., the inflation of coins.
The same logic can be applied to
paper-money inflation. The exchange of nothing for something that the
expansion of money out of "thin air" sets in motion cannot be
undone by an increase in the production of goods. The increase in money
supply — i.e., the increase in inflation — is going to set in
motion all the negative side effects that money printing does, including the
menace of the boom-bust cycle, regardless of the increase in the production
of goods.
According to Rothbard,
The fact that general prices were more or less stable during the 1920s
told most economists that there was no inflationary threat, and therefore the
events of the great depression caught them completely unaware.
Does an
Increase in Commodity Money Cause Inflation?
Now, let us say that on a gold
standard, because of an increase in the production of gold, the supply of
money — i.e., gold — has increased. Subsequently a general
increase in the prices of goods has taken place. Should we label this
increase as inflation? According to some commentators on the gold standard,
an increase in the supply of gold generates similar distortions that money
out of thin air does.
Let us start with a barter economy.
John the miner produces ten ounces of gold. The reason he mines gold is
because he believes there is a market for it. Gold contributes to the
well-being of individuals. He exchanges his ten ounces of gold for various
goods such as potatoes and tomatoes.
Now people have discovered that
gold, apart from being useful in making jewelry, is also useful for some
other applications. They now assign a much greater exchange value to gold
than before. As a result, John the miner can exchange his ten ounces of gold
for more potatoes and tomatoes.
Should we condemn this as bad news
because John is now diverting more resources to himself? No, what is
happening with John the miner is just what is happening all the time in the
market. As time goes by, people assign greater importance to some goods and
diminish the importance of other goods. Some goods are now considered as more
important than other goods in supporting people's lives and well-being.
Now people have discovered that
gold is useful for another use: to serve as the medium of exchange.
Consequently they further lift the price of gold in terms of tomatoes and
potatoes. Gold is now predominantly demanded as a medium of exchange —
the demand for other services of gold, such as ornaments, is now much lower
than before.
Note however, that gold is a part
of the pool of real wealth and promotes people's lives and well-being. Let us
see what happens if John increases the production of gold.
One of the attributes for selecting
gold as the medium of exchange is that it is relatively scarce. This means
that a producer of a good who has exchanged this good for gold expects the
purchasing power of his effort to be preserved over time by holding gold.
If for some reason there is a large
increase in the production of gold, and this trend persists, the exchange
value of the gold will be subject to a persistent decline versus other goods,
all other things being equal. Under such conditions, people are likely to
abandon gold as the medium of the exchange and look for other commodity to
fulfill this role.
As the supply of gold starts to
increase, its role as the medium of exchange diminishes, while the demand for
it for some other usages is likely to be retained or increase. So in this
sense the increase in the production of gold adds to the pool of real wealth.
When John the miner exchanges gold
for goods he is engaged in an exchange of something for something. He is
exchanging wealth for wealth. Also note that an increase in the supply of
gold didn't occur because of an act of diluting gold but because of an
increase in gold production.
Contrast all this with the printing
of gold receipts, i.e., receipts that are not backed 100 percent by gold.
This sets a platform for consumption without making any contribution to the
pool of real wealth. Empty certificates set in motion an exchange of nothing
for something, which in turn leads to the misallocation of resources and to
boom-bust cycles.
Remember, an increase in the supply
of mined gold doesn't lead to the misallocation of resources, i.e.,
employment of resources contrary to the true free market, which reflects
consumers' most urgent preferences. Note again that the number of coins
increased here is not because of the dilution of gold coins but as a result
of an increase in the production of gold, i.e., real wealth. In contrast to the
holder of money out of thin air, the wealth generator — the gold
producer — supports his own activities. He is not engaged in the
diversion of real resources from other wealth generators by means of empty
money. Consequently, any decline in the amount of money out of thin air is
not going to hurt him. (Note a decline in the money out of thin air will
reduce the diversion of resources to activities that emerged on the back of
money out of thin air.)
Conclusion
Contrary to the popular definition,
inflation is not about general rises in prices but about increases in money
"out of thin air." Inflation is an act of embezzlement. On a gold
standard, inflation is about the increase in receipts unbacked
by gold money. On a paper standard, inflation is about an increase in the
supply of paper money. The general increase in prices, as a rule, develops on
account of the increase in money. The harm that most people attribute to
rises in prices is in fact due to increases in the money supply out of thin
air. Therefore, policies that are aimed at fighting inflation without
identifying what it is all about only make things much worse. When inflation
is seen as a general increase in prices, then anything that contributes to price
increases is called inflationary. It is no longer the central bank and
fractional-reserve banking that are the sources of
inflation, but rather various other causes. In this framework, not only does
the central bank have nothing to do with inflation; on the contrary, the bank
is regarded as an inflation fighter.
On this subject Mises
wrote,
To avoid being blamed for the nefarious consequences of inflation, the
government and its henchmen resort to a semantic trick. They try to change
the meaning of the terms. They call "inflation" the inevitable
consequence of inflation, namely, the rise in prices. They are anxious to
relegate into oblivion the fact that this rise is produced by an increase in
the amount of money and money substitutes. They never mention this increase.
They put the responsibility for the rising cost of living on business. This
is a classical case of the thief crying "catch
the thief." The government, which produced the inflation by multiplying
the supply of money, incriminates the manufacturers and merchants and glories
in the role of being a champion of low prices.
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