Inflation: Causes and the Cure

Inflation is inevitable. At least, that is what politicians tell us. They do their best to fight inflation. When they fail, it is because inflation is apparently beyond their control. But what is this economic phenomenon that has plagued all countries around the world for the better part of this century?

To many, inflation is a rise in prices. However, this definition is not precise enough if we are to understand its effect on the economy — to say nothing (yet) of the moral effect of diluting the purchasing power of people’s hard-earned money. The definition functions like a diagnosis.  A doctor who prescribes aspirin for a headache that is caused by a brain tumor will not only miss the tumor, but will kill the patient.  Similarly, if we do not make a correct diagnosis of why inflation is a problem, not only will the cure we propose not solve it, it may even make it worse. 

Defining inflation simply as rising prices too easily permits us to overlook the underlying causes of these rising prices. Therefore, rising prices should be more accurately called price inflation.

There is, on the other hand, an older and more accurate definition of inflation. At one time, any expansion in the money supply was referred to as inflation. By the term money supply, we refer to that which can be used to purchase goods and services. This includes all notes and coins that are in circulation and purchasing power in the form of credit.

Inflation is any addition to the existing money supply (no matter how it is measured). As we inflate a balloon by adding more air to it, so we inflate the money supply by adding more money (or credit) to it. Because of the shift in understanding that has occurred over the meaning of inflation, however, I’ll call this monetary inflation, an inflation (increase) in the quantity of money. ^[1]

What Inflation Does to Your Money

Before proceeding with an explanation of inflation, it helps to emphasize that every investor must come to grips with inflation. It is important that you understand what inflation does to your money over time. Many people don’t realize that inflation is the opposite to compound interest. Whereas compound interest multiplies the return to an investor by giving interest on top of interest, inflation is a compound negative return on capital. This is why inflation is so devastating.

Look at the first two columns in the chart below. In the first column I have shown what happens to $1 as it is depreciated by inflation. In column two, I’ve shown what happens to $100,000 when its value is eroded by the falling value of money. To reinforce the effect, I’ve added a column showing the same effect upon a $500,000 capital base.

Inflation rate:  5.00%

The effect of inflation, even at a modest and steady rate of 5% (in reality, the rate can be much higher, and can fluctuate, sometimes sharply) is devastating. It takes only a little over eight years to wipe out a third of the value of your money.  A handy tool here is the “rule of 72.” This rule tells you quickly how long it will take to halve the value of money. Divide the number 72 by the inflation rate and the answer is the number of years it takes to cut the value of money in half. If the inflation rate is 10%, then the answer is 7.2 years. It takes 14.4 years to halve the value of money when the inflation rate is 5%.

Inflation has such a devastating effect on our wealth. According to Ernest Oppenheimer, “inflation represents a breakdown of the normal rules of the game of the monetary system.”^[2] Almost instinctively, we recognize that those “normal rules” include keeping the value of money relatively intact. Understanding inflation and learning how to protect ourselves against its insidious effects is not an option. It’s a necessity.

Causes of Price Inflation

Imagine that the only economic goods for sale are ten apples. There are, however, ten one dollar coins which can be used to buy these apples. What will be the “price” of the apples? Assuming that the people in this economy actually want to buy and sell the apples, the theoretical average price is $1 per apple. In reality, of course, the better quality apples will fetch a higher price and the poorer quality ones will probably have a lower price. But the average is $1 per apple. If you have understood this much you’re well on the way to becoming a competent economist, or “house manager.”

In this closed economy, how can the average price be increased to, say, $1.50 each apple? It is a simple mathematical problem. The only way the average price can increase is if the ratio of goods and coins is altered, by either eliminating some of the apples or by increasing the number of coins. Assuming the number of apples remains constant, however, the average price of the apples can increase to $1.50 only if there are fifteen coins, instead of ten, to buy the ten apples. Only under this condition, where the money supply is increased while the quantity of goods remains constant (or at least doesn’t increase as fast as the money supply), can the average price level for all the apples be increased.

Simple, isn’t it? As money is pumped into the economy, prices tend to increase. The inflation of the money supply (i.e., increasing the amount of money) causes an increase in prices. This is the cause and effect relationship between prices and the money supply.

Boom and Bust — The Business Cycle

An increase in money stimulates the economy to extra activity. With increased demand for goods made possible by the additional money, buyers signal producers that they demand more product. Producers expand their businesses, employ more people, buy more machines, and generally increase productivity.

Meanwhile, consumers have become used to the new money. They know that they are getting extra money in their pockets every year through monetary inflation. Suppliers pace their production activities on this fact, just as consumers anticipate having the increase next year.

But eventually, without explanation, the money expansion machine is cut off. Instead of an extra 10% people get only 2% extra money. How do people react? They cut their spending to accommodate the new and lower inflation rate. That is, they respond rationally to the changed economic environment in which they find themselves.

With the decrease in demand for their goods, business people cut back production, employ fewer people, and buy less equipment. Unemployment rises, which in turn lowers demand for some goods and services, and the economy is in a decline. This is called a recession, and if it gets bad enough, it’s called a depression. (Or, as someone humorously said, if it happens to someone else, it’s a recession; when it happens to you, it’s a depression.)

Fractional Reserve Banking

Fractional reserve banking is a mechanism whereby the banks create purchasing power through credit without physically creating money of any kind.

Consider this scenario. You deposit $100 in First Security Bank. It is the only money the bank has in its vault. Later, Mr. White comes to the bank to borrow $90 so he can buy some new plumbing equipment for his home. The bank decides it will keep 10% of the money in reserve, but it is willing to lend out the remainder. The bank will not give Mr. White the money, but it will permit him to write out a check for this amount, and provide him with an overdraft facility to enable him to do it. Mr. White gives a $90 check to the plumber, who promptly deposits the check in your bank, where he also has an account.

When you placed your funds in the bank, you received a receipt or a stamp in your deposit book, which says you are entitled to withdraw $100 whenever you like. The plumber has deposited $90 into his account, and the bank has given him a receipt to say that he can withdraw this sum any time he likes. Mr. White, meanwhile, has an obligation to repay the bank the sum of $90.

Now, how much money does the bank have in its vault at this point in time? Go to the top of the class if you said only $100. While it is true that Mr. White must find $90 from somewhere to repay to the bank in the future, plus interest, until that loan is repaid the bank cannot meet all its current obligations. If both you and the plumber turn up tomorrow to withdraw all the funds shown in your respective deposit books, the bank clearly cannot cover the amount. It does not hold the funds in reserve. There is a complete mismatch between the bank’s borrowing on one hand (i.e., your savings), and its lending on the other. It borrows short term but lends long term. (In real life, the banks depend on new depositors and loan repayments to cover demands for cash from depositors.)

The money supply correctly includes the amount of credit in the financial system, as well as the physical stock of money. The credit facility is just as much “buying power” as is the real money itself.

Inflation and Morality

Monetary inflation causes price inflation. While money consists of notes, coins and credit, whose supply is determined by the federal government, monetary inflation is a deliberate act of those controlling the money supply.  But price inflation erodes the purchasing power of money. Just as a thief erodes your purchasing power when he demands you hand over your money, so money devalued by inflation erodes the purchasing power of that money.

When nations have been strongly influenced by Christianity, their approach to money management has maintained a monetary unit that could not be inflated so easily. The British Parliament in the nineteenth century under the leadership of Sir Robert Peel made some attempts to provide a stable currency. Money was primarily silver, and the government found it difficult to increase (i.e., inflate) its supply. Consequently, the country had a steadily falling price level. Sir Roy Harrod made this observation:

Recently people have settled down into thinking that some degree of annual inflation, moderate, it is to be hoped, will continue to be with us as far as the eye can see. This is a rather lamentable defeatism. One might almost regard it as a symptom of decadence. It (sic) we take a backward look we do not find that inflation was endemic in England. For nearly a century after the Restoration (1660) the general trend of prices was downward, subject to transitory wartime interruptions. In the eighteenth century there was a moderate upward movement, doubtless connected with wars, but at the time of the war against the French revolution, prices were still not far from the 1660 level. Then came the great inflation, including suspensions of convertibility. After the war the downward movement, again subject to interruptions, was resumed, and by 1850 prices were below the pre-war level. There was a flattening out in the middle of the century, probably due to the Californian and Australian gold discoveries . . . after which a strong downturn was resumed, bringing prices in 1896 way below their 1660 level. Then came the South African gold discoveries and also the South African war. These events were accompanied and followed by an upward trend of prices. But even in 1933 prices were not above the 1660 level.^[3]

As the Industrial Revolution brought on more goods and services than the existing money supply could buy, the price level tended to fall as the new goods competed for the available money. Everyone wins when this happens. A real growth in goods and services leads to lower prices. The value of money increases and everyone benefits. Appropriately, the poorer classes benefit more than the wealthy, since they have so little money to go around. Any drop in prices has a greater impact on the poor than it does on those with greater wealth.

Monetary inflation on the other hand, because it defrauds people of the purchasing power of their money, is immoral. It is a method whereby the value of money is diluted. Just as it is immoral to dilute wine with water and continue to sell it as undiluted wine, so it is immoral to steal from people by lowering the value of their money. This is the argument that Isaiah brings against the people of Israel (Is. 1:22). The prophet accuses the people of diluting their silver with dross. He equates it with diluting wine with water. In former times, when money was gold, it was diluted by adding cheap metals, which was passed off as pure gold. Today, in an age where money is pieces of paper (or merely bank credits), its purchasing power is diluted simply by creating more of it. No matter how it is done, though, it is still an act of dishonesty concerning the purchasing power of money. And dishonesty is condemned in the Scriptures.

Debt

At the heart of the inflation issue is the question of debt.  Debt is the primary fuel for the monetary inflation fire.  It is also how people are encouraged  to beat the inflationary spiral.  This is like pouring kerosene on a bonfire in an attempt to put it out.  We’re fooled into trying to beat inflation with more inflation.  This is why debt levels are so high.

It is impossible to read the Bible without getting the idea that God does not like debt.  In Romans 13:8 there is the command to “owe no man anything.”  Even if this is not considered an outright prohibition on debt, it is certainly no encouragement to be in debt so readily.  There are many other arguments against debt, summarized in my book, Making Sense of Your Dollars (available from Ross House Books).

Once inflation starts, it is hard to stop. Part of the reason for this is that people begin to have a financial interest in inflation. Imagine buying a home with a 25-year mortgage. By the time the final payment is made, total payments may have been over three times the purchase price of the house. If there were no increase in the price of the home, a substantial financial loss would be incurred by the owner when he sold it.

It can be easy to become dependent on inflation as a means of driving up the price of the house while at the same time depreciating the value of the currency. This way the mortgage is paid off in depreciating currency while at the same time the price of the home rises. With a little providential “luck,” by the time the mortgage is paid off, the price of the home will be at least equal to the amount paid over the duration of the mortgage. This is why debt and inflation go hand in hand. Debt does not necessarily have to lead to inflation but it usually does. This is because, as Rushdoony points out, “all inflation is a form of dishonest debt.”^[4]

This thinking is wrong-headed, though. It assumes that proper economic calculation is possible under inflation. Unfortunately, this is not so. In the words of Solomon Fabricant, former Professor of Economics at NYU:

The variety of ways in which inflation disturbs the calculations and affairs of business is enormous. It is enough to say that inflation acts on prices and costs, and on profits and taxes. It undermines the basis on which past commitments were made, creates current and urgent pressures, and it clouds expectations about the future. It disturbs relations with customers, labor, suppliers, financial institutions, and governmental agencies, and internal relations within firms. And the particular impact of inflation in each of these respects, whether favorable or not, differs widely among firms, depending as it does on the nature of a firm’s business; the age, size and form of its organization; its location; and the way it customarily does its business.^[5]

In other words, in an age of inflation our economic judgment becomes distorted and unreliable.

Unfortunately, not everyone can protect himself or herself against inflation. According to Henry Hazlitt,

[I]n hedging against inflation, each of us can protect himself only at the expense of someone else. Every time we buy some commodity as a hedge, we tend to raise the price for the next buyer. It is possible successfully to practice inflation hedging individually, but never generally.^[6]

In other words, there is no guarantee that you can successfully protect yourself against inflation by adopting certain investment strategies. This should not stop us from attempting to do it, but we need a realistic mindset when dealing with the problem. To ensure that inflation is halted is the only secure protection against it.

Inflation and Liberty

There is a direct relationship between inflation, government control, and personal liberty.  While the government continues to use fallacious arguments that they are controlling inflation, in reality they are merely making things worse. Each time they make it worse becomes another excuse for more government intervention. The cycle needs to be broken. This is why Oppenheimer has argued that “inflation contravenes all principles of sound finance and provides the government with the incentive to move ever deeper into a morass of higher deficits, larger debts, and greater irresponsibility.”^[7] The foundations of liberty are intimately connected with the individual’s ability to look after his own affairs with minimum interference from politicians. But politicians with power cannot halt inflation; only citizens who have the moral will and determination to put an end to financial immorality can.

Conclusion

So what can you do?  To stop inflation you must stop using debt, and you must work to convince politicians to abandon their attempts to control the economy by increasing notes, coins, and credit.  There are obvious problems getting federal politicians around the world to abandon these attempts.

It should be much easier to convince yourself to take one of the necessary steps to halt inflation.  Stop borrowing.  The less you borrow, the more you will personally contribute to stopping the immoral act of inflation.  It is one step you can take immediately to protect your neighbor from inflation.  And if you take the command “love your neighbor as yourself” seriously (Mt. 5:39), you should act immediately — if not sooner — to halt inflation.