Inflation: of all the dangers to the free market economy, historically and theoretically, the greatest is this one, yet it is one of those subjects that remain wrapped in mystery for the average citizen. This elusive concept must be understood if we are to return to the free market, for without a thorough comprehension of inflation’s mechanism and its dangers, we will continue to enslave ourselves to a principle of theft and destruction.
This essay is an attempt to compare the process of inflation to a more commonly recognized physiological phenomenon, that of drug addiction. The similarities between the two are remarkable, physically and psychologically. Nevertheless, it must be stressed from the outset that any analogy is never a precise scientific explanation. No analogy can claim to be so rigorously exact as to rival the accuracy of the original concept to which it is supposed to be analogous. It is, however, an excellent teaching device, and while it is no substitute for carefully reasoned economic analysis, it is still a surprisingly useful supplement, which can aid an individual in grasping the implications of the economic argument.
Before beginning the comparison, it is mandatory that a definition of inflation be presented, one which can serve as a working basis for the development of the analogy.
One workable definition has been offered by Murray N. Rothbard, who is perhaps the most reliable expert on monetary theory: inflation is “any increase in the economy’s supply of money not consisting of an increase in the stock of the money metal.” An even better definition might be this one, adopted for the purposes of exposition in this study: “any increase in the economy’s supply of money, period.” Thus, the level of prices is not the criterion in determining whether or not inflation is present. The only relevant factor is simply whether any new money is being injected into the system, be it gold, silver, credit, or paper.
Unfortunately, many economists and virtually the entire population define inflation as a rise in prices. The more careful person will add that this rise in prices is a rise in the overall price level of most goods in the economy, one which is not due to some national disaster, such as a war, in which the rise can be attributed to an increase in aggregate demand as a result of changed economic expectations. Other economists, even more precise, attempt to define inflation as an increase in the money supply greater than the increase of aggregate goods and services in the economy. Professor Mises himself, in his earliest study on monetary theory, employed a definition involving comparisons between the aggregate supply of money and the aggregate “need for money.” But in later years, he abandoned this definition, and for very good reasons, as he has explained:
There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. “Inflation,” as this term was always used everywhere and especially also in this country, means increasing the quantity of money and bank notes in circulation and of bank deposits subject to check. But people today call inflation the phenomenon that is the inevitable consequence of inflation, that is, the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been up to now called “inflation.” It follows that nobody cares about inflation in the traditional sense of the term. We cannot talk about something that has no name, and we cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy which which must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.
What about the inflation caused by increases in the supply of money metals? How does this come about? There are at least two ways this could happen: (1) new sources of gold and silver might be discovered; (2) a new and more efficient technical process for producing one of the metals more cheaply could be found. This would tend to inject new supplies of circulating media into the economy, but the use of the metals as money could be offset through their consumption in industrial use (silver, for example, is widely used in the photography industry), and as jewelry and ornamentation. Then, too, costs of mining are not any lower, nor profits any higher, in the long run, than in any other industry. Because of these and other limitations on the use of precious metals as money, changes in their supply are relatively insignificant as inflationary or deflationary devices. It must be admitted that the inflation which stems directly from the increased supply of precious metals proceeds in exactly the same fashion as the inflation from other sources, but this kind of inflation is usually on such a vastly smaller scale that it is far less dangerous than the other types, and is therefore of less concern to this study. Since it takes place in the free market, in distinction from both mass credit and currency inflation, its effects are more predictable and less harsh. Free market inflation and deflation, caused by the fluctuation in the supply of money-metals, are inescapable in this imperfect world, but their burden is light. Their evils are compounded sevenfold if men, in their drive for a radical, State-enforced perfectionism, attempt to eradicate this mild inflation or deflation through the imposition of State controls over the money mechanism.
In contrast to the expense and difficulty of the production of precious metals, consider how gloriously simple it is for a government to print a treasury note, or for a bank to issue a paper deposit certificate. The treasury of any nation can begin by promising to redeem all of its notes in stated weights and fineness of a precious metal, proceeding to buy the metals from producers and issuing the notes in payment. In the beginning, the treasury note, like the bank note or bank credit slip, is a legal IOU, a receipt for goods stored, goods that are payable on demand with the presentation of the receipt. So far, so good, but the matter never rests here. The treasury officials realize what the banking leadership realized hundreds of years ago, that few people ever call for their gold or silver. Those who do are normally offset by new depositors, and so the vast stores of money metals are never disturbed. The paper IOU notes are easier to carry, store more easily, and because they are supposedly one hundred percent redeemable from supposedly reliable institutions, these notes circulate as easily as the gold or silver they represent, perhaps even more easily, since the paper has so many useful properties. These paper notes have the character of money — they are accepted in exchange for commodities.
Treasury officials now see a wonderful opportunity for buying goods and services for the government without raising visible taxes: they can print new bills which have no gold reserves behind them, but which are indistinguishable from those treasury notes with one hundred percent reserves. The new, unbacked notes act exactly the same as the old ones; they are exchanged for commodities just as easily as the honest IOU notes are. Governments print the notes in order to increase their expenditures, while avoiding the necessity of raising taxes. The nasty political repercussions associated with tax increases are thereby bypassed. The State’s actions are motivated by the philosophy that the government can produce something for nothing, that it cancreate wealth at will, merely through the use of the printing press. Government attempts to usurp the role of God by becoming the creator of wealth rather than remaining the defender of wealth. The magic of money creation, in its modern form, makes the earlier practice of metal currency debasement strictly an amateurish beginning. If private citizens engage in paper money creation, it is called counterfeiting; if governments do it, it is called progressive monetary policy. In both cases, however, the end is the same: to obtain something valuable at little expense. The result is the same: inflation. In the private realm, with the notable exception of banking, counterfeiting is prosecuted by the government because it is theft. but in the public sphere it is accepted as a miracle of enlightened statesmanship.
Banking practice is quite similar to treasury policy, and the State, realizing that the banks are an excellent source of loans, permits and even encourages bankers to continue this fraudulent counterfeiting. A bank, assuming an enforced legal reserve limit of ten percent (which is about average), can receive $100 from a depositor, permitting him to write checks for that amount, and then proceed to loan $90 of this money to a borrower, virtually allowing him to write checks on the same deposit! Presto: instant inflation, to the tune of ninety cents on the dollar. This, however, is only the beginning. The borrower takes the $90 to his account, either at the same bank or at another one. This second deposit permits the bank involved to issue an additional $81 to a third borrower, keeping $9 in reserve, and the process continues until a grand total of $900 comes into circulation from the original $100 deposit. This practice is commonly known as “monetization of debt,” and the banking system which practices it is called “fractional reserve banking.” Then, too, there is the problem of the original $100. If it should be in the form of treasury notes, then the currency already has been heavily inflated through the government’s counterfeiting practices. If, on the other hand, it is in the form of a check, then it is backed up by only ten percent of some earlier depositor’s $111.11. In any case, the economy is faced with an ever-pyramiding structure of credit inflation, only the pyramid is inverted, with an ever-tinier percentage of specie metals at its base. Money buys less and less as prices soar. Anyone who doubts the magnitude of the effects of this combined bank and treasury note inflation should pause and consider the fact that in the years 1834-1859, the highest per capita total of currency, deposits, and specie in the United States was under $18, and in the low year it was just over $6 per person! In the high year, 1837, there was only $2 of specie to back up the $18, and the banks had to suspend payment, so even in this period the nation was plagued by a money mechanism based upon unbacked IOU notes.
It should be pointed out, just in passing, that the traditional debate over the so-called “wage-price spiral” misses the mark completely. The unions blame management for the increasing costs of all manufactured goods, while business blames the unions as the cause of the price hikes, since added labor costs force management to pass along the wage increases to the consumers. Both groups are wrong. Without the counterfeit, unbacked credit money produced by fractional reserve banking, and without the unbacked treasury notes, neither labor nor business could continually force up prices. Labor would price itself out of the market, forcing management to fire some of the laborers. Businesses would price their products too high, and the public would shift to their competitors. No, the wage-price spiral is only a symptom of the inflation; it is a direct result, not the cause, of inflation. Admittedly, government coercion backing up labor’s demands have made the unions a major source of the pressures keeping costs rising continually, as Henry Hazlitt argues in chapter 42 of his little book, What You Should Know About Inflation. But this should not blind us to the original causes: the treasury’s counterfeiting and the government-protected fractional reserve banking system.
What, then, are the effects of this inflation on the economic system? It is my hope that the answer to this question will be grasped more quickly through the use of the analogy of the dope addict. The nation which goes on an inflation kick, such as the one the United States has been on for well over a century, must suffer all the attending characteristics which inescapably accompany such a kick.. In at least six ways, the parallels between the addicted person and the addicted economy are strikingly close.
1. The “Junk” Enters at a Given Point
This is an extremely important point to understand. The new money does not appear simultaneously and in equal amounts, through some miraculous decree, in all men’s pockets, any more than equal molecules of the drug appear simultaneously in every cell of the addict’s body. Each individual’s bank account is not increased by $5 more than it was yesterday. Certain individuals and firms, those closest to the State’s treasury or the banks’ vaults, receive the new money before others do, either in payment for services rendered or in money loaned to them. Inflation enters the economy at a point or points and spreads out; the drug enters an addict’s vein, and this foreign matter is carried through his system. In both cases, the “junk” enters at a point and takes time to spread.
There are several differences, though, which cannot be ignored. The spread of inflation is far more uneven than is the spread of the drug. The first individuals’ incomes are immediately swelled, and they find themselves able to purchase goods at yesterday’s less inflated prices. They can therefore buy more than those who have not yet received quantities of the new, unbacked currency, and this latter group is no longer able to compete so well as the possessors of the counterfeits. Since yesterday’s prices were designed by the sellers to enable them to sell the entire stock of each commodity at the maximum profit, the firms or individuals with the new money will either help deplete the stock of goods first, leaving warehouses empty for their competitors who desire to purchase goods at the given price, or the new money owners will be in a favorable position to bid up the prices so that the competitors will have to bow out. The first group gains, undoubtedly, but only at the expense of the second group — the group which can no longer compete successfully through no fault of its own. The latter group bears the costs, costs which are hidden, but which are nonetheless there. This latter group is made up of those individuals who have relatively fixed incomes (pensioners, civil servants, small businessmen), and who are forced to restrict purchases due to the now inflated prices.
As the inflation spreads, it increases rapidly because of the fractional reserve banking process described earlier. Prices rise unevenly, depending on which industries receive the new funds first, while the unsuccessful businesses, those without the new money, begin to contract and even to go out of existence.
The inflationary process clearly does not create wealth. It merely redistributes it, from the pockets of those who were successful before the inflation began, into the pockets of those who are successful once its starts. The government can supply its needs without raising the visible tax rate; the banks can make more loans without raising the interest rate (in the short run, although not in the long run). The government, by inflating, imposes an invisible,’ unpredicted tax upon those who cannot pay the new prices, and who must restrict their purchases; the banks, by inflating, force the non-recipients of bank credit to consume their capital by having to pay higher prices, and this tends to bring more people and businesses to the credit department of the banks. In either case, someone pays the costs. The redistribution (and ultimately the destruction) of wealth continues. All this results from the fact that the spread of inflation is uneven, and because all inflation must enter at certain, favored, points.
2. The “Junk” Produces a Sense of Euphoria
The addict experiences a series of strange sensations, some of which may be painful, such as nausea, but which are more than offset by the pleasant results, however temporary these might be. Things seem more secure to the addict, less harsh than before. The drug may produce dizziness, an imbalance, and it certainly distorts the addict’s sense of reality. He moves into a false world, but one which he prefers to the real one, and which he may even mistake, at least temporarily, for the real one, until the effects of the drug have begun to wear off.
Inflation does precisely the same thing to an economy. Prices rise spasmodically, in response to the inflated money injected into certain points of the economy. Money is “easy,” and profits appear to be available in certain favored industries, those industries in which, prior to the inflation, further investment would have produced losses. The entrepreneurs pour capital, in the form of money and credit, into these newly profitable ventures. The inevitable happens: good, solid, formerly profitable businesses that had been beneficial to both buyers and owners in the pre-inflation period now begin to lose money. Costs are rising faster for certain industries than are profits; capital is being redirected into other industries; laborers are moving into areas where higher wages are present. Firms which had just barely broken even before the inflation (marginal firms) may now go under and be forced to declare bankruptcy. They are bought out by the favored industries, and acentralization of production begins, with the favored industries leading in expansion and growth. The marginal firms were not destroyed through honest competition, i.e., because they were unable to offer services equal to competitors, but because some members of the economy have been given access to counterfeit money and are thus enabled to compete with an unfair advantage.
Capital — raw materials, human labor, production machinery — has been redirected, and in terms of the pre-inflation conditions, misdirected. Efficient firms can no longer compete, so they fold up; as inflation progresses, they fold up even faster. Supplies, initially stimulated, may begin to fall as the more efficient firms (in terms of a non-counterfeit currency) collapse. Prices, the guideposts of a free market, have been distortedby the injection of the new money, exactly as the addict’s senses are distorted by the drug, and the economy reels drunkenly. Paper profits appear, followed by rising costs, which may wipe out all the gains. Businessmen are thrown into confusion, as are laborers, housewives, and professional business forecasters: where to invest, what is sound, where will rising costs lag behind increasing profits? Investments go where the profits are, but the profits are measured by a mixed currency: part specie metals and part counterfeit promises to pay specie metal. Counterfeit profits stimulate the creation of “counterfeit industries,” while Wiping out formerly productive enterprises. The redistribution of wealth results in the destruction of wealth, and the consuming public is injured: some have become rich, but the majority pays for its new-found prosperity.
By fouling up the price mechanism, the inflationary drug has helped to paralyze industry. The economy fares no better than the addict. By ignoring reality, i.e., the true conditions of supply and demand, the inflationist economy helps to destroy itself just as surely as the addict destroys himself by trying to escape.
3. The Body Adjusts to the “Junk” and More Is Demanded
The addict’s body eventually adjusts to the drug that has entered his system, compensates for its destructive’ effects, and then attempts to heal its malfunctioning organs. Much the same thing takes place in the economic system. Sellers and buyers adjust their purchases to the new prices and the new wages. But the damage, in both cases, has already been completed. Old cells in the addict’s body, and old businesses and entrepreneurial plans in the case of the economic system, have been eliminated. Things can go forward again, but not at the same rate or in the same direction as they did before. Nevertheless, the organisms are still alive and functioning once again, provided that no new “junk” enters either system.
That, of course, is the danger. The “benefits,” the pleasant euphoria in the addict’s case, and the apparently limitless opportunities for gain in the inflated “boom” conditions of the economy, act as a constant temptation to both to return to the old ways. The successes were too apparent, and the losses so invisible. Who misses a few dead cells, or a few bankrupt businesses? Cells and businesses die every day! But not, normally,healthy cells and productive businesses, and this is what the addict and the inflationists ignore. If healthy cells are destroyed in a human being, sickness is present. The same holds true for the economy.
The addict is tempted, and the second step is always easier than the first; moral and physical resistance is now much lower than before, and so is the initial fear. The resistance to further inflationary pressures is also lower; many in the economy have been made rich by it, and without further inflation their positions of supremacy are threatened. These vested interests do not owe their position to their successful competition; they are indebted to the counterfeiting agencies which have provided them with the additional funds. The counterfeiting agencies do not wish to cease inflating the money supply either. So the addict returns to the pusher, and the economy returns to the banks, and stands, hat in hand, at the treasury’s doors. A new round of inflation begins.
There has been a change, however. Both the addict and the economy require ever-increasing doses of the “junk” in order to obtain the same “kick.” The addict’s body develops a tolerance for the drug, and if the same amount of it is injected into his system, he will begin to lose the old euphoria, and eventually he will experience physical discomfort. In the market, forecasters expect further inflation, and they prepare their plans more carefully, watching for rising costs, and are more ready to increase prices. The paper profits are smaller unless larger quantities of the counterfeit claims are injected into the money supply. The addict’s body continues to decline, and the economy also deteriorates. New bankruptcies, soaring prices, disrupted production are everyday occurrences. The price mechanism is less and less responsive to the true conditions of supply and demand, i.e., “true” apart from monetary inflation.
Another fact that is not generally realized is that the price level may remain somewhat stable while inflation is going on. Just as the addict can take a small quantity of a drug and still seem normal, so the productive economy can seem healthy. Both addict and economy are filled with the foreign matter, whether the signs show or not. Take away the drug, and both the economy and the addict would be different. The laymen, and a considerable number of economists, forget that in a productive economy, the general level of prices should befalling. If the money supply has remained relatively stable, the increased supply of goods will force down prices, if all the goods are to be sold. In fact, the free market should generally be characterized by increasing demand prompted by falling prices, with increasing supplies due to increased capital investment. If prices remain stable, then the economy is very likely experiencing inflationary pressures. The public has erred in thinking that an increasing or even stable price level is the sign of “normalcy.”