Monthly Archives: June 2012

The Dangers of Inflation (No, Not Just Price Increases)

Here, we will define inflation as an increase in the supply of money rather than an increase in the price level. The latter is done generally by modern mainstream economists. However, the former is the fundamental causal factor that leads to the latter effect as well as to a number of other harmful effects. This distinction may not seem very important at first, but it is necessary to isolate causal factors to properly explain how the economy works. (This will be demonstrated further below)

When the supply of a good is increased, its price goes down. The same phenomenon occurs with money. As the supply of money is increased, its price, i.e., its purchasing power, declines. Thus, ceteris paribus, other prices increase. The ceteris paribus condition is very important. It is possible in a productive economy for prices to stay the same or even decrease as the money supply is massively increased. This is because the productivity of the economy is increasing at an equivalent or faster rate, therefore neutralizing the increase in the money supply. A good example of this was the 1920s, where the money supply was increased throughout the decade, but prices stayed stable. This is because productivity increased as well and thus the price level stayed approximately constant.

To explain what I was saying previously, an economist without knowledge of causal relationships would look at the 1920’s and see no price inflation. They then would assume that because of the relative price stability, inflation could not be a possible factor in leading to the stock market crash of 1929. The logic would be as follows: if a variable stays constant, how can it be the causal factor of a certain effect? Sounds like a silly mistake, but yes, that’s how most economists think (with exception to the Austrian school).

So the first effect of inflation we have expounded are increases in prices. Why is this a bad thing? Price inflation, ceteris paribus, means a lower standard of living.

However, prices do not all rise proportionately to an increase in the money supply. This leads us to our second point, Cantillon effects.  When the money supply is increased, the individuals who get the money first have the ability to spend it first. The goods and services they spend it on rise in price because of the additional demand for these products.  However, the individuals who receive the money last end up spending the money after prices have already risen. Thus the individuals who received the money first gain at the expense of the individuals who receive the money last. This leads to large amounts of inequality in the population.

So, in the United States, when the money supply is increased, who gains and who loses? Money is created by the Federal Reserve and the fractional reserve banking system. The Fed buys bonds in the creation of money. Therefore, the federal government is the first beneficiary of the newly-created money. Logically, the things it spends on tend to rise in price before others can take advantage of the money. Unsurprisingly, many of the things the federal government spends on have risen in price exponentially, such as housing (before the housing collapse of 2008), education, and health-care. Increases in the money supply are also created through the fractional reserve banking system. Since fractional reserve banks only have to keep a fraction of the money they owe, money that is given to them to hold is multiplied. For example, with 10% required reserves, if $100.00 is given to a bank, the bank can use all $100.00 as reserves and create $900.00 to loan out to others (assets will equal liabilities here, assets = $100.00 vault cash + $900.00 loan, liabilities = $100.00 in first individual’s checking account and $900.00 in new individual’s checking account). When money is created in this fashion, the newly-created money is loaned out, generally to individuals who are using the money to invest. Many of these beneficiaries happen to be on Wall Street.

The poor suffer higher prices while the already-rich gain at the poor’s expense. The left commonly makes the argument that we have to raise taxes in order to combat inequality. But a far more effective and morally superior way would be to just stop the money printing. That way, wealthy individuals who earn their fortunes voluntarily by selling products that consumers desire would not be affected; however, wealthy individuals who gain through the creation of money will no longer possess their unfair advantage.

The third effect of monetary inflation we’ll discuss is the business cycle. I will not go into the fine details here (that would add quite a bit to an already-lengthy entry), but I’ll save that for a future post and instead outline the basics.

Interest rates are a price: the price of money with respect to time. On a free market, an increase in the supply of funds that can be loaned, i.e., savings, would be associated with a decline in the interest rate. Increased savings would reflect the preference of individuals to consume in the future rather than consume in the present. So naturally, a lower interest rate would be consistent with this desire: firms would be able to borrow more with lower interest rates and invest in the higher orders of production (capital equipment)which lead to more goods in the future rather than in the present. Here the desire of firms and the desires of consumers match. Consumers want to consume more in the future and because of the lower interest rate brought on by increased savings, firms want to produce more in the future.

When money is artificially created through the banking system, there is more money that can be loaned, and the interest rate is lowered. This makes it seem as if there is a larger supply of savings, but savings have not actually increased. A mismatch has been introduced: firms want to produce more in the future while consumers do not want to consume more in the future (relative to their previous preferences). Investors are misled into believing previously unprofitable activities are now profitable because of the lower interest rate and tend to invest more heavily in the higher orders of production. This is the boom period.  Everyone is happy, stock prices are rising, and consumers are spending themselves into debt because of the lower interest rates.

But the malinvestments are eventually realized. Persistent inflation can prop up the malinvestments for a period of time, but eventually interest rates will rise and activities profitable under lower interest rates will become unprofitable again. These malinvestments will have to be cleared for the economy to recover. Any more inflation will just create more malinvestments and delay the process.

Notice how this theory, called Austrian business cycle theory, is consistent with Say’s Law. The malinvestments refer to a misallocation in resources. There is no general overproduction, but rather overproduction in some areas (higher orders of production) and underproduction in other areas (lower orders of production). Students learn in Econ 101 that price controls have malevolent effects in creating shortages and surpluses, but what they don’t learn is that the interest rate is a price, a price affecting the whole economy. And a price control, through the artificial toy of monetary inflation, on a price affecting the whole economy has consequences far worse.

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Say’s Law, Part 1: Exposition

J.B. Say was a 19th century French economist whose work was mostly ignored by mainstream economists other than for one minor aspect of his economic theory that came to be known as “Say’s Law.”

Say’s Law states that the demand for a good is made up of the production of other goods. This can be clearly demonstrated by an imaginary barter economy. Suppose there are only two goods, fish and potatoes. If an individual wants to buy a fish, he must exchange a potato for the fish. He could not buy the fish without first producing the potato. Thus, the production of the potato is what constitutes the demand for the fish. And vice versa. The production of the fish is what constitutes the demand for the potato. Now, if the individual who wanted the fish did not produce a potato to use in exchange first, there would be no economic demand. All he would have is desire. But desire is only one part of demand, the other being the ability to actually buy the product. And this ability only comes with production.

In a large economy, the production of a larger amount of goods will make up the demand for the fish. And in a money economy, money only being a medium of exchange, producers will exchange their products for money and then exchange money for the fish. The only difference is that there is an intermediate step.

Why has an economic law so simplistic attracted so much attention? Rothbard explains:

Say’s law is simple and almost truistic and self-evident, and it is hard to escape the conviction that it has stirred up a series of storms only because of its obvious political implications and consequences. Essentially Say’s law is a stern and proper response to the various economic ignoramuses as well as self-seekers who, in every economic recession or crisis, begin to complain loudly about the terrible problem of general ‘overproduction’ or, in the common language of Say’s day, a ‘general glut’ of goods on the market. ‘Overproduction’ means production in excess of consumption: that is, production is too great in general compared to consumption, and hence products cannot be sold in the market. If production is too large in relation to consumption, then obviously this is a problem of what is now called ‘market failure’, a failure which must be compensated by the intervention of government. Intervention would have to take one or both of the following forms: reduce production, or artificially stimulate consumption.

This underconsumptionist theory is what Keynesians believe causes the business cycle. But as Rothbard explained, the underconsumptionist belief far predated John Maynard Keynes.

If Say’s Law is true, there cannot be a general overproduction (the flip side of underconsumption) of goods on the free market. However, there can be overproduction in one area and underproduction in another, a misallocation of goods. This insight will help us understand what really causes business cycles, which will be explained in a future post.