Thursday, May 5, 2011

Why is Inflation so Bad?

I intend to have a much more detailed answer to this question some time in the future, but for now I thought that I would try to answer the question in a somewhat limited fashion. The word inflation has a few different meanings. Today when most people hear the word they think about a general rise in prices, or about stagflation in the 1970s. It is easy to see why this definition is popular today. Price inflation hurts and it is obvious. It makes food and gas and all goods more expensive, and we feel the pinch directly. Back in the 1800s, though, the word inflation had a very different meaning. Rather than price inflation, it meant monetary inflation, that is, a general rise in the supply of money. Now this is interesting, because today monetary inflation happens and it happens to a great extent. No one is going to deny that fact. However, central banks think that they can get away with it because price inflation is not all that high. They think that they have fooled us.

I will not go into how price inflation is bad, because that is obvious. Monetary inflation, on the other hand, hurts us in a more indirect way. The easiest way to see this is with simple economic analysis. By the laws of supply and demand, we know that when supply has increased, price will decrease, all other things being equal. So when we have a higher supply of bills, therefore, the value of each of those bills will be lower. Now, some will point out that the all other things being equal stipulation is not always true, and granted, it usually is not true. However, the fact remains that the value of the bills is lower than they otherwise would be without that inflation. There is no way around that fact. Therefore, monetary inflation makes us poorer than we would be, and that is always true.

Though this seems bad, this is not the most sinister effect of monetary inflation. A more thorough analysis of the issues requires looking at the practical way that government have gone about instituting that monetary inflation. In the United States, at least, the monetary inflation comes about when the Federal Reserve purchases treasury bills (that is, the debt of the United States). The Federal Reserve, in essence, is lending money to the United States, but that money is newly printed (in effect). The government then goes out and spends this money, usually with new construction jobs. These jobs use up capital like machines and raw materials and labor. Now, inflationists like to say that this has no effect on interest rates. They are right, this aspect of the Federal Reserve does have no effect on interest rates. They then go on to say that capital markets are not affected. On that point, they are dead wrong. The new construction projects undertaken by the government necessarily use up capital, and this means that capital goods are more expensive for everyone. So even though interest rates have not gone up, businesses now need to get a bigger loan in order to cover the costs of their projects. Even if the price of capital goods has not gone up in time, they are necessarily higher than they otherwise would be. But why is this bad? Because government is necessarily less efficient than the private sector. They undertake projects based on what is politically favorable; they do not base it upon consumer demand. So the cost of the things we want, essentially, go up because the government is building things that we do not want as much. That makes us worse off.

So do not be fooled by Ben Bernanke prattling on about how prices are not rising, so his actions are not affecting us. He is lying. Monetary inflation is hurting us, both directly and indirectly. We are less wealthy than we otherwise would be without the inflation, and goods are more expensive than they otherwise would be because the price of capital has gone up. Just say no to monetary inflation. It is a recipe for destroying wealth.

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  1. Another aspect of monetary inflation is that whoever gets to use this new money first gets the advantage of it not yet becoming devalued.

    Later, when the dilution effects of the new money are felt, the "first spenders" have already locked in a tidy profit. The rich and moneyed adjust accordingly, but the working people have no recourse and just have to take it.

  2. Sooner or later, the chickens always come home to roost.

  3. Silverfiddle, I would have loved to talk about that part and how it distorts the structure of production. It's kind of a complicated topic, so I hope to talk about it when I do my very long post on inflation.

    Jim, no doubt. The elite think they can play games and get away with it, but reality always sets in no matter how smart you think you are.