The Damage of Inflationby
Dmitry Chernikov My article on how money is created still left many unanswered questions. Here I attempt to make the causes and consequences of inflation clearer. 1. Inflation is often called printing money, and the word conjures up images of printing presses working round the clock to churn out $100 bills that are shipped by truckloads to the Department of Treasury. In fact, all money creation is done via the banking system, and the task of the Bureau of Engraving and Printing is merely to accommodate the demand for paper dollars when the newly created checking deposits are cashed in (withdrawn). There is no connection between the cash printed or destroyed and the change in the money supply. It is possible that the supply of money increases but the demand for cash goes down to such an extent as to cause the quantity of cash on hands to decrease. 2. Both the banks and the federal government benefit from inflation, but in different ways. For the former there are at the first glance two apparent such benefits. First, they can now treat checking and saving accounts as CDs and loan them out, even though these are redeemable on demand. Second, they can loan out a lot more cash than they have in reserve. The banks’ assets can cover only a fraction of their liabilities in case of a bank run. These may look impressive, but they are, in fact, trivial advantages, and in the long run they don’t not even matter, because the temporarily higher profits will attract other banks in the industry (since there are no barriers to entry) and lower the profits to their normal rate. Even with a 100% reserve requirement banks could compete with each other, innovate, provide better service, and thereby attain higher profits than the duller of their competitors. The privilege to defraud is, in the long run, useless to the banks. The only genuine benefit they enjoy is a much-reduced possibility of business failure or bankruptcy. The Federal Reserve stands ready to loan the banks any amount of cash to help them with any difficulty. This protection from entrepreneurial errors courtesy of the paternal central bank makes banks somewhat like government enterprises; it causes listlessness and lassitude, discourages innovation, and makes banks less interested in serving consumers. In the US, unlike, say, in Argentina or Zimbabwe, the expansion of the money supply does not directly benefit the federal government. That is, the Treasury cannot order the Fed to buy its newly issued securities; it has to compete for capital on par with everyone else. But it nevertheless enjoys the following three advantages: First, it benefits from inflation in the same way any other borrower does: it gets to borrow money at lower interest rates. Second, it pays no interest at all on securities held by the central bank. As the Fed itself states, "Federal Reserve Banks are not… operated for a profit, and each year they return to the U.S. Treasury all earnings in excess of Federal Reserve operating and other expenses." The Fed does not appear to advertise its income, but for an estimate we read that "Net miscellaneous receipts for the second quarter of fiscal year 2006 were $11.2 billion, an increase of $3.5 billion over the comparable prior year quarter. This change is due in part to deposits of earnings by Federal Reserve banks increasing by $3.3 billion." So the government might get around $40 billion in these "odds and ends," of which, let's say 75% comes from the Fed, which means that, given that the Fed’s share of securities (as contrasted with that held by the public or in government accounts) at the end of 2005 was approximately $745 billion, the average interest rate is somewhere around 4%, a reasonable number, so everything adds up. (What is the difference between the Fed’s holding bonds and the public’s? The difference is that the Fed’s buying securities is inflationary, while the public’s is not. The very purpose of the Fed is to inflate.) Third, unlike private debtors, the government never has to pay back the principal. The debt is not expected to be retired. Everybody knows and is resigned to this. So when the bonds mature, the Treasury issues new bonds of an even greater total value to pay off the old ones. So this is a Ponzi scheme made more attractive by the fact that the Fed's never-ending money creation puts more cash in the hands of the public and lowers the interest rates the government has to pay. In this way the debt is never paid but is continuously "monetized." The government enjoys interest-free money which it never expects to pay back, which causes the debt to grow every year. An organization could not have gone into $8 trillion debt without the ability to inflate. Not even the power to tax would have been of help here. At some point the lenders would have realized that any attempt to actually repay the debt would ruin the economy, interest rates would have skyrocketed, and the government would have had to break its contracts and default. Why then do people keep buying government bonds? Because these bonds are backed "by the full faith and credit of the U.S. Government." Because the world is on a dollar standard (there is nothing better for now). That’s why, for example, from 1995 to 2005 the value of the Fed’s portfolio increased almost two-fold – it is the means by which the scam continues. And it will keep increasing until a real reform takes place. In short, then, central banking allows governments to keep piling up new debt despite the mountains of old debt they already acquired. The reason for that is that lenders are kept comfortable knowing that the US can always inflate away its liabilities. Although this possibility would seem to be a cause of alarm rather than freedom from care, nonetheless, it is this power to inflate, coupled with the above-mentioned dollar standard, that makes US government bonds "risk-free." 3. What is the connection between the growth of the money base and the manipulation of short-term interest rates? Both are initiated by the Fed. The greater the growth of the money supply, the lower the interest rates will be, because banks will have more cash (which they pyramid on top of their reserves) to loan before prices rise everywhere; so the supply curve moves to the right and, the demand being the same, the rate of interest will decrease. The banks are also expected to extend loans to individuals previously thought to be uncreditworthy. Similarly, if the Fed tightens, such as through its "open market" operations, the banks will have to contract the money supply and the now greater scarcity of money will cause interest rates to go up. The effect on long-term interest rates is less obvious. As a simple deduction, inflation benefits debtors, because they have to pay their debts with ever less valuable dollars; deflation, creditors. Thus inflation causes interest rates to rise, because creditors want to get their money’s worth despite the inflation’s harm to them. As Professor Michael Ellis writes, "If people believe inflation will rise because of the open market purchase, they will only be willing to hold longer-term securities if they pay higher interest to compensate for the loss of purchasing power of the dollars they will earn in the future. This effect is stronger for longer-term securities than shorter-term securities. Thus, it is unclear that long-term interest rates will fall along with the short-term interest rates after an open market purchase by the Fed." 4. Inflation does not cause all prices to rise at the same time. Money is injected into the economy at specific points, and those who get the new money first benefit, because they can spend it long before all prices rise (not necessarily absolutely but in comparison to what they would be in the absence of inflation) in response to the now lower purchasing power of money. Those who receive the money last will lose, because they will be faced with higher prices and the same incomes. So inflation is redistribution of wealth initiated by the Fed. But who will benefit and who will lose is entirely unpredictable and random and different every time. If, for example, the created money goes into the stock market, and there is a high-tech boom, then the wages of computer programmers will be bid up, sometime quite a bit, and they will be one of the beneficiaries of the easy money policy. 5. This kind of redistribution, unjust though it may be, is, however, economically irrelevant. Some lose, some gain; in the end there is neither a net loss not gain. But the manipulation of interest rates is a form of price control. The gold standard is a market mechanism, under which the correct rate of interest (that is, the measure of consumers’ time preference) is determined "automatically." How can the central bank succeed at doing the same? The government cannot set prices, and neither can it correctly set the price that the lenders charge the borrowers for postponing their consumption. This is precisely why the Austrian Business Cycle theory, which I believe to be correct but which is beyond the scope of this essay, states that booms and busts are attributable to the Fed’s inevitable errors in setting the interest rates. This economic sickness makes the economy, for lack of a better word, crazy. Entrepreneurs are tricked into defying consumer wishes. Ambitious projects are undertaken only to fail because of the ultimately revealed if slowly acknowledged lack of sufficient savings to fund all of them. At the start of the boom the prices of capital goods rise, because there is more money chasing them, yet consumer spending does not correspondingly diminish. As a result, there is not a sufficient quantity of complementary capital goods to sustain the projects. E.g., if Crusoe on his island somehow overestimated the average quantity of fish he caught in his nets every day and decided to embark on the project of planting a garden, the garden could not be completed, because while Crusoe is working on it, his nets fall into disrepair and eventually stop catching anything. If he does not want to starve, he would have to abandon the unfinished garden and go back to mending the nets. In the real world things are more complicated, but the basic story is the same – worse, actually, because Crusoe could go back to working on the garden later, while most of the ruined enterprises are ruined for good. It is only luck if the capital and even labor (which is the most non-specific factor) tied up in them could be used for other purposes. The theory gets complicated quickly, with various objections and replies, but the conclusion is that these systemwide dislocations make us all poorer and less rational. In a recent working paper economist Michael Thornton has applied the ABCT to housing bubbles. The bubble "bursts" when consumer time preferences "reassert themselves" (not his phrase) in that the business plans of marginal entrepreneurs are shown to be faulty, because they do not reflect the future inflationary price increases within the housing industry. The "reassertion" does not happen immediately, because (1) it takes time for prices to rise and for the less alert investors to be forced out of business, and (2) monetary expansion is continuous, prolonging the correction. As a result, homes are repossessed by the banks (who don't want them), half-built homes are left unfinished, investments in capital goods used in construction go bust, skills that marginal homebuilders develop are rendered useless, and so on. So things that used to contribute to people's happiness stop doing so. The physical objects are still there; they just don't do anything anymore, especially if they are not convertible; that's why people become poorer. Thornton concludes that
The paper makes it clear, though without explicitly stating as much, that the Austrian "real changes" are different from the mainstream changes in stressing the actions of the government not of private citizens, and the Austrian "psychological changes" are different from the Keynesian changes in attributing the busts not to Keynes’ irrational "animal spirits" but to the producers’ false views of the consumer desires that the Fed induces during a preceding boom. (That is, entrepreneurs make mistakes all the time, but they don’t need to be misled even further by the government. And even if they realize that cheap credit is dangerous for them, they have no choice but to take advantage of it, because their competitors, who may have received the new money despite their relative incompetence, surely will. It has been argued that the recent corporate scandals, such as with Enron, were due precisely to the established companies’ getting worried and confused about the apparent success of the newcomers and trying to get ahead no matter the cost.) 6. Deflation can be defined as (1) a diminution of the total money stock, or (2) the lowering of the price level, insofar as the latter can be estimated by Mises’s "judicious housewife." The second effect is, in fact, what economic progress is all about. Nominal wages on average can stay the same under gold standard; but real wages, i.e., the stuff that you can buy with your money, will rise through an ever greater variety of products and services and their ever increasing quality and lower prices. Deflation in the second sense is perfectly great. Deflation in the first sense, however, is treated by some economists with horror. But this appears to defy reason. These phenomena, inflation and deflation, are perfectly symmetrical to one another. How can in a free society (e.g., one lacking any "downward wage rigidity") expansion of the money supply produce happiness, and its contraction, misery? What are the causal laws according to which deflation allegedly threatens economic well-being? I would need to be presented with a step-by-step chain of events that gets us from "deflation" to "inefficiencies" or "depression," and I don’t know of any such deductive, Austrian-style, real-world economic reasoning. So I am very skeptical of the claim of the evil of deflation. 7. The interest on the government debt adds to the total tax burden. Now, of course, the whole purpose of borrowing is to raise revenue without raising taxes. But if the government squanders the money instead of somehow "investing" it properly, e.g., by providing the kind of public goods that promote prosperity (assuming that such a thing is possible), a likely outcome, then interest payments become simply another form of government spending. In 2005 this outlay consumed $178 billion. 8. The Fed is not fully independent of politics. And that, probably, is the most sinister and horrifying aspect of our monetary system. The Fed has the power to create a potentially infinite amount of money. It is constrained only by the costs of paper and ink, not by any genuine scarcity. It can cause hyperinflation and thereby destroy the economy and society. If the federal government were to incur enormous liabilities, due to its warfare and welfare (such as Social Security and health care subsidies), which neither taxes nor borrowing could finance, it would certainly have the central bank fire up the virtual printing presses and perhaps even "nationalize" the Fed. So our entire economy is in perpetual danger from the unstable and dangerous men in the White House. The possibility of hyperinflation is always there, and if it happens, life as we know it will be turned upside down. The gold standard would bring enormous stability to the world economy. It would serve as single international money, uniting the world even closer into a single market, and it would not be liable to be made worthless (and therefore to lose all utility as a medium of exchange, unit of account, and store of value) by any insane state.
I thank Professor Joseph Salerno for his helpful comments on the earlier draft of this article. September 21, 2006 Dmitry Chernikov [send him mail] is a graduate student in philosophy at Kent State University. Copyright © 2006 LewRockwell.com |
I
fully admit that the government’s power to create money scares me,
because these guys are completely unpredictable, constrained by
very little, and I just don’t trust in their goodness. And
I think you shouldn’t either.