Introduction to
Economics
Lesson 06 / 07
INFLATION
Inflation is one of
the most discussed topics in Economics.
It is however one of the least understood and most widely
confused, even amongst economists.
To a large part, this arises from its close connection to, and
intertwining with, the political process.
What is
Inflation ?
Confusion begins
with defining just what is Inflation.
The most popular and accepted definition is that Inflation is a
persistent and general increase, within an economy, of prices, and a
commensurate decrease in the value of money.
Critics of this definition maintain that this merely identifies a
typical symptom of inflation. A
better economic definition of inflation is any increase in the volume of
money.
Attitudes
towards Inflation
One of the most
significant distinguishing features of the various schools of economic
thought is their understanding of, and attitudes towards, inflation. This in turn is a key towards the acceptance and application
of the teachings of one or other particular school. In so far as any
particular school regards inflation as capable of having a beneficial
affect it can be described as, to a greater or lesser extent,
inflationist.
Only those schools
that regard and teach that inflation is, and always is, detrimental to
the general well being of a society can be properly described as
non-inflationist. With that
distinction in mind we can examine 3 particular major modern schools of
economic thought; the Keynesian, Chicago [or Friedmanite], and the
Austrian.
In simple terms an
inflationist would be one who regarded any increase in the quantity of
money as always being of benefit to a society.
In affect, more money equals more wealth or purchasing power.
More purchasing power will lead to the creation of the various
goods and services that will enable the increased purchasing power to be
used and enjoyed by the holders thereof.
Generally speaking,
most people can see the flaw in a pure inflationist policy.
After all if more money is the answer where are we to stop.
Should every member of a society be given $1 million, $10
million, $50 million? Would
anyone be better off?
Since WW2 the major
school of economic thought has been the Keynesian.
In certain circumstances it regards inflation as having a
beneficial affect. In
particular it regards it as a cure for depression.
More money can be used to get industry moving again and to
restore full employment. Once
this has been achieved judicial use of the taxing power can be used to
fine tune the economy and prevent the inevitable rise in prices from
becoming rampant. Keynesians are thus qualified inflationists.
Disillusionment
with the dominant Keynesian policies became widespread in the 1970’s
with the advent of stagflation, that is to say rampant rising prices
accompanied by low or falling productivity.
In 1977 the US dollar was losing value at the annual rate of 6%,
the Spanish peseta at 17.5%, the Italian lira at15.7%, the British pound
at 14.5%, the Swedish Krone at 9.5%, and the Japanese yen at 9.1%.
Other parts of the world, including, in particular, Latin America
did significantly worse. Australia
too suffered.
Keynesian theory
called for the government to inflate during depressed periods. This was attractive to those who benefit from inflation, in
particular the government. In
good times the excess purchasing power was to be soaked up by increased
taxation and reduced spending. The
problem is that increasing taxation and reducing spending is politically
difficult at any time.
As people have lost
faith in Keynesianism the views of the Chicago school, particularly
those of Milton Friedman have gained favour.
Members of the school are sometimes referred to as Monetarists.
Monetarism regards inflation, by which is meant a persistent
and general growing increase in prices, as an unqualified evil.
It is caused by the increase in the creation of money exceeding
the increase in the supply of useable goods and services.
The solution, initially, was seen to be to match the increase in
the creation of money to the increase in production of goods and
services. In that way
prices would remain stable. Subsequently,
as the difficulties in actually doing that have become more apparent,
the suggestion has been that the money supply should simply be increased
annually at a predetermined and unchanging fixed rate.
If not productive of absolutely stable prices it would ensure a
degree of predicability.
Unlike the
Keynesians and the Monetarists, the Austrian school is opposed to any
increase in the money supply whatsoever.
It is this that they regard as inflation and which is
unqualifiedly bad. To help achieve their goal, many members advocate a return to
commodity money. Eschewing
inflation renders the school particularly unattractive to those who
benefit therefrom. Relatively
the school is marginal with little political influence.
Economically however its ideas are innovative and convincing.
What’s Wrong
with Inflation
The creation of new
money does not mean that goods and services will forthwith exist to be
purchased with the new money. More
money chasing the same amount of goods and services means higher prices.
Inflation creates
various groups of winners and losers.
The primary winner, at least in the short term, is government,
which creates and gets to spend the new money first, before the rise in
prices. Thereafter those
who receive the new money early, often those directly involved with
government receive a benefit, but one decreasing as the new money loses
value. Those towards the
end of the queue, including those on relatively fixed incomes such as
wage earners, pensioners, retirees and creditors generally suffer
significant losses, since they pay higher prices, before and often
without any increase in nominal income.
Inflation is generally hard on the middle class.
Conversely borrowers do particularly well since they can
eventually repay their loans in devalued money.
Inflation is a tax.
For a variety of reasons it is a particularly bad tax.
It is an indirect and surreptitious tax, easy to introduce,
difficult to remove and hard to quantify.
By creating new money government is able to pursue its ends,
which we can assume are admirable in themselves.
Nontheless, in so doing they perforce consume resources for which
government would otherwise have had to raise the money to pay for,
either by tax or by borrowing.
Inflation is
unsustainable. As money
loses value people begin to lose faith in it and avoid accepting or
holding it, preferring items more likely to retain value. This leads, if
unchecked, to the demise of the currency, which in turn leads, absent a
medium of exchange, to the destruction of the economy and possibly to
civilisation itself
Inflation leads to
scapegoating. It is a
monetary phenomenon which first and always is the creation of
government. Yet as the
difficulties associated therewith increase there arises a desire and
need to shift the blame. The
usual suspects are then trotted out and popular resentment directed
towards them; greedy shopkeepers, the oil companies, Arab sheikhs, the
unions, speculators, farmers or whatever.
Needless to say it is none of their fault.
Inflation leads to
the introduction of counterproductive policies such as wage and price
controls and indexation. The
way to stop inflation is to cease creating new money.
Indexes and controls merely mask the problem; indexes inevitably
lag and controls prevent the market from operating or are avoided. Both target those who are not to blame and penalise the ones
suffering the most.
Can Inflation be
used to Cure Unemployment?
It used to be
thought that you could have a trade off between inflation and
unemployment. Arguably if
unemployment existed the government could create money to employ the
unemployed on public works. However,
as the stagflation of the 1970’s, [when there co-existed both
inflation and unemployment], showed, such solution can be short term at
best, and thereafter the consequential effects on the economy are such
as to create a situation worse than before.
History
During the era of
commodity money, particularly that of gold and silver, the ability of
rulers and governments to inflate was severely constrained. They were largely confined to debasing or clipping the
currency. Inflation when it
occurred was, with one major exception, temporary and episodic,
associated with major events such as the American and French
Revolutions, the Napoleonic and US Civil Wars or with major discoveries
of gold and to a lesser extent silver, such as in California, Australia,
Alaska and South Africa. The
major exception was the C16th, the century following the discovery of
the New World, when gold flooded into Europe through Spain causing,
major and persistent inflation throughout the century in a number of
countries, and leading in no small way to the demise of the Imperial
Spanish economy.
Traditionally the
alchemist’s dream was to turn lead into gold. The world’s rulers and
governments have been more pragmatic and more successful.
Combined with Legal Tender laws they have discovered a way, via
paper money, to turn paper into gold.
This has led to an era of persistent inflation.
Since WW1 the
typical national currency has lost approximately 90% of its value and
inflation has become accepted as a constant fact of life.
From time to time and from country to country when a government
has become particularly greedy or proved especially inept the inflation
becomes overwhelming and the particular economy collapses.
Currently one of
the world’s leading contenders for economic collapse is Zimbabwe. Fuelled by its government’s resort to the printing press,
its present rate of consumer price rise is estimated at 1,730 %
annually. As a side effect
of this, the Zimbabwe stock exchange is the best performing in the
world, up 12,000 % in the last 12 months.
This is not, however, a sign of economic success. Holders of
Zimbabwean money, desperate to find something that might hold its value,
have been pouring it into shares.
David
Sharp
24 April 2007