Ramifications of Inflation

Inflation occurs when people in an economy are supplied with more money than they need. How much money do they need? The real demand for money is whatever the people in our economy demand when they approach Z.

The economy is supplied with $10 because A approaches Z and demands money. In my example Z acts completely "demand driven".

If that economy was supplied with more money than it needed the value of money would decline and in most cases prices would go up. This includes not only consumer goods but also assets like stocks, bonds and real estate.

What is the negative impact of the inflation that we are facing? One could think that if people are supplied with more money it should not hurt them if prices go up, since they now have more money to spend.

This would actually be true if the money was supplied evenly to all individuals. In that case inflation would not be a problem.

Problems arise if the exuberant money supply is only provided to one group of people. That group of people would then be an inflation beneficiary while the individuals not supplied with money would be inflation losers.

(Please note that an excessive money supply indicates that the entity that is providing the product money is failing to do its job. In a fair and free market, if someone does not do his/her job right or provides bad products or services people start looking at other providers of that service. In today's world central banks are by law the only entity that have the permission to print and provide money for the people living within the respective country's borders. This is enforced by federal law and forced upon people. Hence, there are few ways for individuals to avoid the negative impacts of inflation and there is no natural market mechanism forcing the central bank to do a good job.)

The process of supplying economies with money is in reality a little more complicated than what I described in the article "Money". However, that description gave you a very good understanding of what the purpose of money is, why it exists, what value it provides to people using it and how it could possibly be introduced as an innovative product into a rudimentary economy for the first time.

The Process of Supplying Money

In all major industrial countries central banks provide money by buying government bonds. What does this mean exactly?

Understanding this requires a detailed understanding of government finances.

The entity government has two ways of financing itself: taxes and debt. Lets say in our 5 people economy person A says:

"I will provide services that benefit everyone and I need money to pay for this." Lets assume all other participants trust A. Lets also assume people trust A so much, they give him/her the permission to create rules that everyone needs to abide by. A creates tax laws that state that everyone has to pay him/her a portion of the money they make by providing products/services. The first thing A pays for with the tax money is a strong person that makes sure people follow his/her rules, that person represents police. It is now clear to everyone that A will not have a hard time making enough money at any time as long as he/she is able to enforce his/her rules.

In addition A establishes a rule stating that Z shall be under his/her supervision, be paid out of the tax money and make decisions "independently" and claims that Z's main job shall be providing the participants of the economy with money in case they need money.

In addition to taxes A (who represents government) can borrow money from individuals. It does so by selling a government bond to an individual that entitles that individual to a certain stream of payments. For example, government receives $10 from individual B and promises to pay $0.45 a year and pay the $10 back at the end of the 3rd year. Government has now borrowed money by issuing a 3 year treasury note at 4.5% and at a value of $10. Government debt is now $10.

The $10 treasury note that B owns is a very safe investment and the likelihood of default is very low because government has the ability to force individuals to pay taxes and can adjust the amount of taxes people have to pay. Hence, the treasury note is a safe investment as long as government can force individuals to pay taxes and individuals produce just enough to live and to pay their taxes.

Please note that individual B has already created value before in order to be able to afford the $10 treasury note. The common word for value created but not used for consumption is "savings".

Now lets say individual B wants to buy something that someone else produced that costs $10 but does not have any more money. What B has is the treasury note worth $10. B would now sell the note on the open market. In case there is no other individual who wants to buy the note, in other words, if the economy's money demand exceeds its money supply, person Z (who represents the central bank) would print money and buy the note from person B for $10.

Z would now be entitled to the annual payments of $0.45 and the payoff of the face value of $10 at the end of the 3rd year after issuance of the note. Whenever money gets back to Z this means that money is pulled out of the circulation and discreated. Z does NOT use the money to consume, all he/she is supposed to do is providing the service of printing money and injecting it into or pulling it out of the circulation. He/she is paid for this job separately out of tax earnings.

Up to now nothing has gone wrong. A seems to be providing services the participants of the economy demand, people are paying their taxes, and Z increases money supply only when money is needed and acts "demand driven". There is no inflation in this example.

How does inflation arise?

Lets go back to individual B owning the $10 treasury note. Lets now assume B does not want to buy anything and there is no supply that matches any of B's demands. Person Z, because for some reason he/she thinks the economy needs to be supplied with more money, now approaches B and wants to buy the treasury note. This is the way central banks act, backed by the virtue of law and all governmental forces available. They don't react to demand for money but rather declare and supply a certain amount of money they think is appropriate.

(For a centralized institution, at any point in time, it is virtually impossible to determine the exact demand for money ex ante, just as it is impossible to determine the exact demand for computers, cars, bread or movies or any other products that are produced in a more or less free market. We are all more or less convinced that the regulatory collectivist governments of the soviet union have failed due to this very reason. We accept that government should not produce computers, cars, bread or movies but that it should rather be up to private, forceless organizations or individuals to deliver these products or services. Yet, we still fail to understand that the product money is still being provided in the most centralized and collectivistic manner possible: central banking.)

Because B does not see any reason to sell the note, Z needs to offer B more money for it than $10. Z offers B $12 for the note, B gladly agrees and the deal is closed.

The economy as a whole now has $12 excess in money supply. At the same time the value of a 3 year $10 treasury note that pays $0.45 a year for 3 years plus $10 at the end of year 3 has now gone up to $12 on the open market. This means that the annual interest rate it pays has now gone down to $0.45/$12 = 0.0375 = 3.75%.

B now has $12 in cash that he/she does not need and that he/she is looking to reinvest safely. B has real demand for savings. The reason why people demand savings is that they want to make sure they can retire once they turn older and become incapable of producing.

What is government most likely going to do now? Currently government has borrowed $10 cash and owes Z (the current holder of the 3 year note) $0.45 a month and $10 at the end of year 3. Government can now raise more cash at a lower rate. It will issue a new 3 year note that pays $0.45 a year and $10 at the end of year 3 and sells it to B for $12. B has invested his $12 safely at the current market rate for 3 year notes, 3.75%. His/her overall nominal situation has not changed. B still receives $0.45 a year and $10 at the end of year 3 after issuance of the note.

Government in total has now raised $22 in cash. Please note that $12 out of those $22 are not matched by any supply on the market. Government however has to and wants to do something with this money and in reality governments never have problems spending money. Governments naturally do not have demand for savings because they don't need to save. Governments can always raise money by forcing people to pay taxes and naturally do not need to worry about savings.

Government will purchase an existing product on the market. The price for that product will inevitably go up afterwards because as we determined there is no additional supply matching the excess money. Wealth has been shifted to government. All other participants in the economy are worse off because prices increased without them having more money in their pockets.

This would not have happened, had Z not supplied the economy with money it did not need based on its natural development and expansion.

We have now gone through the process of printing money and we have seen how new money ultimately ends up in the hands of government. We have determined in the beginning that inflation causes problems if excess money is not provided evenly but rather to a certain group of people.

In our example this group of people is represented by government. Government is the main inflation beneficiary while all other participants are inflation losers. Governments all over the world keep increasing their debt while central banks are providing more and more money.

In my simple example here I assumed that government is represented by ONE individual.
We all know that government in reality consists of a multitude of people, paid with the money government makes by raising taxes and issuing government notes and bonds. It is very important to understand that we have to differentiate between the entity government itself and its representatives and officials. Those individuals are paid with government money, personally they do not have any obligation to the people government borrowed money from. The entity government itself still remains liable for all its debt while its officials don't. Government officials are the people who make the decisions on what to do with the money. The burden is ultimately on all those people who are not enriching themselves as government officials by paying themselves excess money, ultimately it is on the taxpayer whose tax payments serve as a collateral for all government debt.

I will write a separate detailed article about this but my general point of view is: Checks and balances in governments usually fail because bureaucrats have accomplished a governmental structure where government is not removed in case it pursues substantially flawed politics.

Governments, once elected, generally stay in power for a certain term and the way they finance themselves is widely accepted. Governments are controlling most of the economic information published and relentlessly exploit the fact that people mostly do not have enough knowledge about money, inflation, and government finances.

As long as people do not understand that central banks are the root cause of inflation or even become comfortable with the fact that there is inflation and that we have to live with it governments can stay in power and pursue inflationary policies and benefit from it.

There are certain means that enable mainstream economists and politicians to achieve the aforementioned:

• Using a wrong inflation indicator: Mainstream economists and politicians like to use a certain set of product prices (basket) as inflation indicator that usually stays at around 2%-5%. This leads people to believe that there is no significant inflation. They even come up with indicators like the "core inflation" that for some reason omits oil prices. How about we just remove all products from the basket and luckily announce that we have finally achieved a permanent 0% inflation?

• Keeping the inflation within certain limits: In order to avoid a hyperinflation which entails a so called bank run and a complete collapse of the monetary system and hence of governmental power, inflation has to stay just below a certain level. This way people rather accept that they have to live with it. This requires certain times where the central bank slows down the growth of money supply. These are the times where the central bank appears to bravely step up to the plate in order to fulfill its solemn duty of "fighting inflation". This procedure entails a period of declining prices, for example on the stock markets or in real estate, and of an overall decline in the in the growth of the number and value of products produced. Assets or products that were previously overvalued due to the previously exuberant money supply are now beginning to lose value due to the slowdown in money supply. The artificial demand for products and assets declines, people start losing their jobs, especially in the fields that were mostly affected by inflation. A good example is just ahead: we will see this very soon in the real estate industry. Overall production growth slows down. This period is called a "recession".
  

Consequences of Inflation

In the following I will describe the main problems that arise if central banks and governments keep pursuing inflationary policies. These problems would not occur if the central bank actually did what it is supposed to do and if it did not base and justify its existence on forceful laws.

Unfair shift of wealth

Inflation beneficiaries can buy products and assets at low prices. After that fact, prices for those products would go up reflecting the now lower supply. The inflation beneficiaries own products and investments that are now worth more while inflation losers are facing higher prices and a lower life standard because they cannot afford products they were able to afford before.

Misallocation of resources

Because prices for certain products and assets are rising people realize that there is money to be made. These are what I call "inflation adaptors". They start doing work that deals with selling products with rising prices.

An example would be the stock brokers during the inflationary boom prior to the stock market crash in 1929. An excellent current example is the real estate industry. The housing sector, which typically represents just 5% of the total economy, accounted for 50% of the overall growth in the U.S. economy in the first half of 2005. More than half of the private payroll jobs created since the fall of 2001 were in housing-related sectors.

People start working in sectors and providing services that they would not provide if there was no artificially created demand for those products due to exuberant money supply.

Business cycles

Due to the ever instable nature of today's process of money production and supply we have massive ups and downs in the amount and value of products and services provided by individuals and entities. This entails a permanent cycle of boom and recession along with ever changing numbers of unemployment and growth.

People have been conditioned to accept this as a "natural" inevitable phenomenon that is inherent in the nature of the economy. Mainstream economists and politicians tend to blame problems on "the overall economic circumstances" during bad times, again exploiting the fact that most people do not have sufficient knowledge about money, inflation, and government finances. (Other popular scapegoats for these governmental failures are evil speculators on financial markets, mean big corporations that greedily jack up prices to make more money, mean big corporations who fire people because they enjoy doing it, foreigners who dare to have the indecency to not buy our products anymore, terrorists, communists, capitalists etc... whatever is convenient to pick at a particular point in time.)

This point of view implies that "the economy" is an entity, if not a creature of its own that permanently changes its state of mind if not its mood for no particular reason.

If however you trace these problems back in an elaborate and thorough manner you will realize that government, in particular the central bank itself is the very reason for these instabilities.

Frustration

People who do not benefit from or adapt to inflation do not understand why wealth can be a result of a lucky investment and why the dollars they earn with hard work buy them less and less.

The main problem here is that people are not informed about the root cause. So they begin blaming random or seemingly obvious scapegoats that are presented to them by government.

The apparently unfair redistribution of wealth naturally causes frustration and a climate of uncertainty and rivalry which again affects overall economic conditions, people's lives, their relations amongst each other and their well-being.

Vicious inflation cycle

The only times your hear mainstream economists and politicians complain about the central bank are when the growth of money supply is slowed down in order to avoid hyperinflation. The majority of people follow accordingly, not knowing the true circumstances and the reasons why this is happening in the first place.

As Mises puts it:

"As human nature is, everyone is prone to overrate his own worth and deserts."

Hence, people tend to take credit for money they make during inflationary times, instead of realizing the true reason is the policy of the central bank. Then, in times of recession people see that the central bank slows down monetary growth and blame the recession solely on the insufficient supply of money.

This ensues a vicious cycle. Instead of realizing that the reason for the recession is the preceding inflation, people call for more inflation in order to end the recession.

More power to government

Government, as the main inflation beneficiary, has created an environment where there is always demand for its government bonds.

We have seen that it has the ability, at the expense of the private sector, to make more money by persuing inflationary policies and hence stabilize its power of forceful rule over people from the private sector.

I will get into this in detail in a separate article: We should never forget that when governments first started inflation, it was because they had to find a way to finance their bloody and forceful wars. No one would finance those on a voluntary level so goverments found a simple solution: printing money out of thin air, of course at the expense of the inflation losers.

Ultimately, inflation takes freedoms and liberties away from people and fosters a more and more unethical and forceful establishment of government, government agencies, and government contractors.