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The Consequences of Inflation
What would happen if the conventional definitions of inflation and deflation were dropped and, as in Part I, they were defined instead as changes (an increase in the case of inflation and a decrease in the case of deflation) in the stock of money and money-substitutes? First, to an extent that depends upon one’s definition of money and money-substitutes, one would belatedly realise that rates of inflation have long been and presently remain much higher than is ubiquitously supposed. If so, then neither Australia nor New Zealand could be considered “low inflation” countries; nor could their respective Reserve Banks retain their reputations as resolute fighters of inflation.
In Australia, for example, the Reserve Bank increased the supply of money and money-substitutes at an average annual rate of 6-7% (with occasional spikes of up to 12-14%) during the 1990s. None other than its Governor, Mr Ian McFarlane, told the Victorian branch of the Economic Society of Australia on 10 February 2000 that few (apart, presumably, from those eager to borrow) have recognised just how expansionary Australian monetary policy was during the boom period of the late 1990s. Indeed, the Reserve Bank’s quarterly economic statement released on 16 February 2000 stated that “inexpensive and freely available credit” was driving Australia’s rapid growth. The RBA’s statement, in the words of the Australian Financial Review (17 February) ”portrayed an economy reaching its speed limit, fuelled by loose credit and rising asset prices.”
In this respect Australia is hardly alone: according to figures compiled by Gerry van Wyngen, inflation of the money supply in OECD countries has proceeded at an average rate of 7% per annum since 1988, and increased dramatically from a low of 3% in the mid-1990s to 11% in 1999. Indeed, in an interview with Forbes published on 27 December 1999, James Grant, editor of Grant’s Interest Rate Observer, stated that ”the [U.S.] Federal Reserve is expanding its balance sheet at year-on-year rates of about 13%. Fannie Mae and Freddie Mac [financial intermediaries backed indirectly by the U.S. government] are expanding balance sheets in excess of 20%. One can observe extremely brisk rates of overall growth in debt. If inflation were a stock, you’d want to own it. It’s selling below book value.” On 22 December 1999, van Wyngen reported to the Australian Financial Review: “the Fed has pumped the system full of money. The U.S. monetary base has jumped an incredible 20% annualised in the past three months … These are not just huge cash injections, they are so large that they are completely unprecedented. Banks are awash with money, and not just in the U.S., but also in Europe and the Asia-Pacific region.” On this latter point, Bridgewater Associates, the economic research firm based at Westport, Connecticut, reported in January 2000 that the Bank of Japan “has been adding yen to the banking system at rates which are magnitudes above the largest that have ever been seen in the past.” Clearly, then, when inflation is properly seen as an increase in the money supply, then inflation in Australia and elsewhere is currently much more pronounced than central bankers, politicians, economists and investors have recognised.
Inflation as Redistribution By Stealth
This alternate definition also helps us to understand why inflation is such a pervasive and insidious phenomenon. New money is typically created directly by a country’s central bank and indirectly by its treasury. If a government’s expenditures exceed its receipts, it may instruct its treasury to sell bonds to individuals, institutions and commercial banks. Central banks buy treasury securities from the commercial banks and other institutions, paying for the bonds with cash from their own account. They can also expand credit by lowering the discount rate (i.e., the rate of interest charged to commercial banks and other financial institutions) or by reducing the reserve requirement imposed upon cheque or savings accounts in commercial banks.
When paper money, demand deposits, etc. are created by a central bank, its first recipients (e.g., those selling goods and services to the government or receiving financial assets from the government) are able to use their (generally higher) receipts, wages and so on to buy more goods and services (or, in the case of commercial banks, conduct more lending and other financial activities) at initially-unchanged prices. Who gets the new money first? The primary beneficiaries of inflation tend to be commercial banks and those to whom they lend, and large corporations that require long-term financing. Beneficiaries also include employees and owners of real estate in major financial centres. Investors have long known that financial centres such as New York, London and Tokyo have benefited greatly from investment booms. Far less appreciated is the extent to which these “market centres” maintain a relationship with government which is not fundamentally different from that of individuals who receive income support: each depends upon governments in general and central banks in particular for their gilded prosperity.
Business economists are also well aware that long-term projects (including the repayment of residential mortgages) gain disproportionately from the lower interest rates, easier terms and larger loans that typically accompany the creation of money not backed by savings. New projects involving heavy machinery, construction and R&D benefit tremendously from the inflation of the money supply. Hence the prominence of the residential and commercial construction industries in the coalition for inflation; and thus the increases in the prices of equities and real estate (and the confusion of these price increases with an “increase in wealth”) that typically follow inflation.
If the prices of the goods they sell rise faster than prices of the goods they buy, then the subsequent recipients of this new money also benefit from inflation. To the extent that the prices of what they consume begin to adjust (i.e., rise) in response to inflation, however, subsequent recipients benefit less and less from inflation. And those who receive the money last (or not at all), who often include self-financed retirees and residents of regions remote from financial centres, suffer: they find that the prices of the goods that they buy have increased but the prices of the goods that they sell (or the assets that they own) have hardly moved.
The Moral Bankruptcy of Inflation
Clearly, then, the effect of inflation is far from uniform. It creates groups who enjoy windfall gains at others’ expense and as a result of their privileged association with government. The new paper money, demand deposits, etc., thus bestow no net benefits upon their recipients; they impart no demonstrable benefits upon some without simultaneously imparting demonstrable (though far less visible) harm upon others. This is the beauty of inflation – for its beneficiaries – and helps to explain why it has become so popular: modern banking practices highlight its short-term benefits upon “winners” (who are disproportionately debtors and residents of major financial centres) and camouflage its insidious effects upon “losers” (who tend to be creditors and residents of provincial, regional and rural areas). The consequences of a once-only inflation are short-term and dissipate once prices adjust to the increased stock of money. But inflation is seldom a short-run affair; that is to say, central banks inflate more or less continuously. In this respect inflation has insidious long-run consequences. Because it enables them to repay debts in money whose purchasing power has been eroded, thereby reducing the burden of debt, inflation favours debtors. For the same reasons it punishes savers and creditors, promotes deficit spending by governments and individuals and thereby undermines traditional virtues such as saving, abstinence, diligence, sobriety and thrift (see S. Ikeda, Dynamics of the Mixed Economy: Toward a Theory of Interventionism, Routledge, 1997, ISBN: 0415089336 and Australia’s Post-Olympic Reality Cheque). Inflation also makes economic calculation and the distinction between real and illusory returns more difficult and therefore encourages financial speculation and recklessness (the classic statement, originally published in 1932 as The Bubble That Broke the World, is G. Garrett, Where the Money Grows: Anatomy of the Bubble, John Wiley & Sons, 1997, ISBN: 0471238988; see also Interest Rates, Corporate Debt and the Business Cycle). And above all it redistributes wealth by stealth. Not surprisingly, then, central banks, inflation and interventionist government tend historically to go hand in hand (for magisterial and admirably clear overviews of fractional-reserve banking, see Rothbard’s What Has Government Done to Our Money? and The Mystery of Banking).
The 1920s, 1990s and Noughties
Third, to define inflation as an increase in the supply of money or money-substitutes and to understand that its effect is not uniform helps us to understand something that from a mainstream perspective is perplexing: the occasional co-existence of booming business conditions and virtually stable producer and consumer prices. Such a state of affairs existed during the 1920s, parts of the 1950s, the 1990s and into the present day. Inflation causes the purchasing power of money to fall and hence prices to increase. But it need not do so – indeed, it seldom does so – uniformly. Changes in prices have real (i.e., behavioural) as well as monetary causes. If real causes (such as rapid technological improvements or organisational efficiencies or both) exert a downward influence upon prices but increases in the money supply exert an upward influence, then no visible change in the price level may occur. More generally, each individual reacts differently to the gains and losses generated by inflation and adjusts his relative spending patterns accordingly. Therefore, says Rothbard, “all prices will not increase uniformly; the purchasing power of the monetary unit will fall, but not equiproportionally over the entire array of exchange-values.” During times of inflation, in other words, producer prices (including wages, salaries) and consumer prices may increase modestly or not at all – and prices of shares, bonds or real estate may blow through the roof. (Hence a $64,000 challenge put by James Grant: “here’s something I’d like a full-blown Austrian economist to tell me. Why is it that a certain redundancy of credit and money in central bank assets at one point in the cycle can give rise to inflation in common stocks, but at another point in the cycle, it gives rise to an inflation of goods and commodities but not of common stocks? Why does the excess seem to flow into variable channels? In 1946, we got high meat prices and low stock prices; in 1996, we get low meat prices and high stock prices. Why is that? Maybe an Austrian business cycle theorist can write a book – in English – explaining that mystery”).
According to Friedrich Hayek, Wilhelm Röpke and Murray Rothbard, just such a situation occurred in Europe and the U.S. during the Roaring Twenties. And if contemporary proponents of the “New Economy” and its impact upon productivity are correct (see Measuring Productivity Dangerously), such a situation recurred during the 1990s and continues today. The consequences of central banks inflationist policies during the 1990s thus registered on residential house prices, the Dow, S&P 500 and above all the Nasdaq rather than the prices of raw materials, goods or services. Accordingly (and as Rothbard demonstrates in America’s Great Depression), to equate stable prices with the absence of inflation is to risk reaching very misleading conclusions about the present state and health of economic conditions.
Inflation and the Business Cycle
Fourthly, and perhaps most ominously, using this new definition we can see how inflation produces demands for goods and services which are not supported by the temporal structure of production and consumption, and which thereby exacerbates the business cycle from stochastic “ups and downs” to systematic “booms and busts.” To see this, note that a rate of interest ultimately reflects individuals’ perception and valuation of time. The “natural” rate of interest, as the Swedish economist Knut Wicksell first expressed it, indicates the extent to which individuals are willing to forego consumption today in the expectation of greater consumption in the future. The greater their willingness to divert current consumption into current investment and the expectation of future consumption, the lower the natural rate of interest, and vice versa. (For a full explanation, see The Robinson Crusoe Ethic Versus the Distemper of Our Times).
Yet in an imperfect world the natural rate is seldom the rate that prevails. The rate of interest that does prevail, the money rate, is set by the policies of commercial and central banks. If the money rate is set lower than the natural rate, then the pace of credit creation quickens: seeing that it pays to borrow (i.e., that the cost of credit is less than what seems likely to result from a new investment purchased with that credit) businesses and individuals have an incentive to apply for loans.
More generally, consider two types of economic development: growth induced by individuals’ savings and growth induced by credit created by banks. Their effects are initially very similar but their eventual consequences are entirely different: savings create opportunities for the growth of genuine wealth whilst credit unsupported by savings begets unsustainable booms and unavoidable busts. The level of savings and investment is determined by the supply of and demand for loans. Supply reflects the willingness of individuals to save and lend their savings at various rates of interest; and demand reflects the willingness of businesses and individuals to borrow and undertake investment projects. The higher the rate of interest, the greater the extent to which, other things equal, individuals have an incentive to forego jam today, lend their savings, receive interest payments over time and thereby have more jam in the future. Yet higher interest rates increase the cost of borrowing and thus reduce borrowers’ willingness to incur debt. The market-clearing (natural) rate of interest represents a compromise between individuals’ supply of and businesses’ demand for funds; and associated with each market-clearing rate is an amount of funds saved, lent and borrowed.
If individuals become more thrifty, future-oriented or otherwise become more willing to forego consumption today in order to consume more tomorrow, they save more and thereby increase the supply of lendable funds. As a result of this increased supply, the rate of interest falls; and as a result of this decrease of the rate of interest and cost of borrowing, businesses are enticed to undertake investment projects that they previously considered unprofitable. At this lower market-clearing rate of interest both the amounts of saving by individuals and investment by businesses increase. To the extent that businesses invest wisely and increase the economy’s capital base and productive capacity, they produce genuine wealth and enhance everyone’s material standard of living.
Consider now a situation in which (i) individuals’ thrift, orientation towards the future and willingness to forego consumption today, etc. remain unchanged and (ii) the central bank or commercial banks (or both) create credit and inject it into credit markets. Given this inflation of the supply of money, the market-clearing rate of interest falls and businesses and individuals are tempted to borrow. Projects and investments which would not have been considered viable if the rate of interest had not been influenced by the banks, and which therefore would not have been undertaken, are now regarded as profitable. Indeed, objects of expenditure that would not otherwise be regarded as “investments such as residential real estate, are so regarded in the wake of inflation.
Depending upon the amount of credit created and injected and the number of investment projects undertaken, a “boom” is initiated. Given the decrease of the rate of interest and the unchanged proclivity towards thrift, however, individuals’ incentive to save falls. Padding the supply the lendable funds with money not derived from savings thus pushes the market-clearing rate of interest to an artificially-low level. It also drives a wedge between individuals’ savings and businesses’ borrowing. The low rate of interest, in other words, has stimulated borrowing: but has not stimulated – indeed, it has discouraged – saving. Under these conditions credit is relatively plentiful but savings are relatively scarce; and to the extent that wealth derives from savings rather than credit the boom rests upon weak and ultimately unsustainable foundations.
Inflation, Lending and Debt
Inflation, then, usually makes its presence felt first in the market for loans. It changes the costs and benefits of borrowing and hence the incentive to accumulate debt; and it tilts the structure of production towards more time-consuming and sophisticated (“lengthier”) processes. This reaction to inflation seemingly but erroneously signals to entrepreneurs that a decrease in the natural rate of interest has occurred; and the larger the inducement to borrow (i.e., the more profligate the central bank’s inflation) the lower the market rate of interest is likely to be pushed.
The sustainable length of the structure of production thus depends upon the natural rate of interest. The structure at any given point in time will tend to be just long enough to exhaust the fund of savings generated by the natural rate (for details, see The Robinson Crusoe Ethic Versus the Distemper of Our Times). But the future is unknowable, some degree of entrepreneurial error will inevitably occur and so perfect correspondence between the rate of time preference and the length of the temporal structure of production is unlikely. If the structure is too short relative to the rate, then there will exist unused capital available for deployment on more marginal projects; and if the structure is too long, then the fund will be expended before production is completed.
In the absence of a central bank’s intervention, then, stochastic ups and downs of trading and investing conditions – but not a systematic business cycle – are likely to exist. But when inflation causes new money and money-substitutes to pour into the loan market, and depresses market rates of interest below the natural rate, the potential for even greater cyclical disturbances is created. A structure of production with a rate of return equal to or higher than the natural rate is sustainable. But one with a lower rate is not, since individuals would prefer to consume now rather than await the return promised for the future.
The situation under these circumstances resembles that of a builder who has oversized a set of foundations and discovers, once much of the structure has been raised, that there are insufficient bricks to complete the house. Also, because individuals have all the while actually preferred to consume, upward pressure may be exerted on the prices of consumer goods. To complete the capital projects that they have commenced, and both spurred and reassured by the apparent economic boom, entrepreneurs such as builders and residential mortgagees, among many others, will seek to borrow even more at subsidised market rates of interest. Continued expansion of credit is thus required to maintain the boom. Sooner or later, however, either commercial banks (worried about the increasing pace and declining quality of credit) or the central bank (fearful of incipient or actual increases of the prices of raw materials, consumer goods and services, and assets that results from its inflation) must slow the boom. They do so by intervening in the various markets for loans, i.e., by increasing short-term market rates of interest. As Part I noted, on 20 March and 17 April 2002 the Reserve Bank of New Zealand did exactly this.
...continued in Part III
 
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