What is inflation?

Christopher Pang

Hyperinflation at its worst

Mainstream economists tend to define inflation as the rise in general level of prices of goods and services. The Austrian School of Economics asserts that inflation is an increase in the money supply, and rising prices are consequences of monetary inflation. Inflation is an indirect tax on anyone owning currencies as the effect is a loss in purchasing power over time.

There are generally two ways which money supply could be increased in a fiat currency economic model, through printing of new monies by the central bank or by having a fractional reserve banking system which is employed in most financial systems today. However, most central bankers and politicians conveniently distort the true economic effects of inflation by redefining inflation as rising prices. This draws attention away from themselves, the main culprits for inflation.

Fallacy of inflation

When central banks inflate the money supply, the excess money enters the economy at specific places and at different times, not spread evenly throughout. By creating additional money in the economy, the excess money exerts downward pressure on the price of money also known as interest rates to people today. The supply and demand of money should determine the equilibrium price of the money. However mainstream economists neglect this simple fact and further alleges that demand for money is infinite because everyone would never reach a point where they deemed to have enough of money.

Therefore they concluded that since demand for money is infinite, the only way to ensure that people do not hoard money and reduce the velocity of money is to control the money supply with a central bank. Austrian economists have disproved this fallacy of infinite demand because people must always continue consuming on some level regardless of their expectations. Since people must consume, they must also continue producing so that there can be some form of adjustment and full employment regardless of the extent of hoarding.

The primary reason for inflation is excessive money printing by the central bank, otherwise known as monetizing the debt in mainstream economics recently. To demonstrate the harmful effects of deliberate counterfeiting, we shall attempt to look at an example of a group of counterfeiters who were highly equipped with the latest printing technology that prevent them from being detected by authorities. After printing exactly the current amount of money in circulation, they would take this newly created money and spend it in the economy, e.g. buy goods/services, investments or repayment of debt.

As this new money spreads, it bids up prices as the money in circulation is now doubled but the goods/services remain at the same level of production. Suppose there is no change in velocity, prices will eventually double because goods/services generally require land/labour/capital and these resources are scarcer than paper money. Therefore printing more money does not produce additional resources to create an increase in productive capacity.

How inflation distorts economic reality?

Inflation does not generate any benefit for society. It merely redistributes wealth in favor of the early recipients at the expense of the laggards. It further penalizes thrift and encourages debt for any sum of money will eventually be repaid in lower purchasing power than when originally received. It endorses risk taking because of the illusory profits created by inflation. People get drawn in to the “capital appreciation” generated by inflation and such expectations are part of the assumptions used in valuations for their assets.

Furthermore, it keeps businesses which should have failed in business through the historical accounting practice. Business owners paid for their revenue generating assets for their business and accounts for the assets at “historical cost”. During an inflationary period, replacement cost of asset will be higher than the historical cost. Therefore inflation grossly overstates business accounting profits and business owners are unknowingly consuming their own capital sustaining their business. They could be making accounting profits but economic losses after adjusting for inflation.

Inflation also creates illusory profits for shareholders and real estate owners. The capital gains that were acquired during inflation could be drawn out with a margin trading account to leverage up or with a reverse mortgage where equity could be withdrawn based on market value of the real estate. Such credit access further creates an inflationary effect on the money supply as asset prices will constantly push towards a bubble like economy before ending very disastrously which we have witnessed a couple of times in the last decade, with the dot com bubble and the subprime crisis in US.

Hyperinflation is inevitable

History has not favored fiat currencies. In the last hundred years we have seen the fall of Wiemar Republic, Hungary, Yugoslavia, Argentina, Venezuela, Turkey and most recently Zimbabwe. All these historical examples were a result of excessive monetary printing by the government/central bank. The latest country to fall to hyperinflation was Zimbabwe, where inflation rate reported to be at 89.7 sextillion (10^21) percent in 2008, about 14% increase in prices daily.

The naivety of a government in thinking that it can generate wealth just by printing money with a printing press is inconceivable. As a result, queues formed outside banks everyday to withdraw their savings/income and supermarkets to get rid of their money to buy food items. Prices skyrocketed to trillions of dollars for basic food items such as eggs and bread. It is common to see someone carrying a wheelbarrow of money to a supermarket just to buy a loaf of bread during periods of hyperinflation.

Every dollar the government prints and spends is an obligation of the government to make good on the promise of the value of the dollar. However the fall out of the gold standard in the 70s has since reduce the fiscal discipline on government to do what is necessary to maintain the value of the dollar against gold as citizens can no longer redeem the currency in gold.

The money supply has since been multiplying at tremendous rates and we have seen asset bubbles forming one after another around the world. It is by no means coincidental that low interest rates with expanding money supply creates mal-investments and form asset bubbles which destroys wealth once the confidence fades off.

The value of a currency is merely a function of overall confidence in the nation’s ability to make good on the value. However consistent fiscal deficits will impair the nation’s ability to recover from an economic crisis, leading to a depression and a total collapse of the financial system and economy. The inevitable result is hyperinflation and it is not whether it will happen, but when it will happen. “Coming soon to a country near you.”