Inflation - Its Societal and Economic Implications

Table of contents

1. Historic and modern definition

2. The effects of monetary inflation
2.1 Consumer price inflation
2.2 Asset inflation

3. Impact on society
3.1 The winners of inflation
3.2 The losers of inflation

4. Is inflation a natural phenomenon or a policy tool?

5. Future outlook for price inflation

6. Bibliography

1. Historic and modern definition

The understanding of the cause and effects of inflation is crucial to understanding its impact on society throughout history. Inflation was a main cause for empires to fall. By lowering the metal content of the coin or nowadays with the issuance of an ever increasing amount of “paper currencies” backed by “nothing”, a debasement of the currency was and is a direct consequence. With the debasement of the currency, people are deprived of the purchasing power of the currency. Before we look at the ramifications of inflation, a correct and distinct definition of the term inflation is required. The word inflation is derived from the Latin “inflare” and means to increase or to balloon.¹ In this context it relates to the increase of money supply by continuing government issue of currency.

Up until the 1940s the term inflation only referred to an increase in the money supply beyond the increase in goods and services during a given period of time.² By this definition, the cause of inflation is easy to determine; namely the institution issuing the currency. From the 1940s through to the present day, the prevailing definition of inflation significantly varies from the historic definition. The standard definition of inflation today adopted by economists and the mainstream press is that inflation is an increase in prices. This change of the meaning of the term inflation is by no means harmless since it paved the way towards inflationism. As we will see later on in this study, inflation has been prevailing in the industrialized countries since World War I and has been exacerbated by the complete demonetisation of gold in 1971 as President Nixon closed the “Gold window”.

By focusing on the term inflation I will rely on the historic and the Austrian economic definition due to its longer period in use and its higher accuracy. The modern definition of inflation as simply rising prices looks more at the symptoms of monetary inflation and not at the cause. An understanding of the real cause of inflation is vital to an understanding of fixing it once it reappears.

2. The effects of monetary inflation

Inflation or more accurately monetary inflation always brings with it side effects. To look at the extent of monetary inflation, chart 1 on page four illustrates the annual broad money supply growth rate of change M3 of the United States and the total amount of M3 in billions of US dollars. For the sake of argument let us assume that the economy has been growing on average by 3% over the years. We can then state, that the difference between the money supply growth and the annual growth of the goods and services is the monetary inflation. The excess increase of the money supply will inevitably affect the prices of assets, goods and services. However, excess money supply will not affect prices of all the goods and services to the same extent and at the same date. Money is never neutral, this means that prices do not fall or rise proportionally with the increase or decrease of the quantity of money in circulation.³ But monetary inflation will have a pronounced impact on consumer prices, asset prices and on the distribution of wealth within a society. Although there are several more effects adhered to monetary inflation I will only focus on the subsequent effects.

Chart 1: Broad money supply annual growth rate of change (absolute figure in billions)⁴

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2.1 Consumer price inflation

The most severe and perceived effect of monetary inflation is the increase in the price of consumer goods. Normally there is a lag effect of several years between the increase of the money supply and the rise in consumer goods.⁵ The newly created money has to find its way through the economy first. The faster the money is spent, that is to say the higher the velocity of circulation, the earlier is the increase in the price of consumer goods and services. The increase in consumer goods is measured by the Consumer Price Index. Although the general price level may rise, prices of butter percentage wise may rise higher than the price of meat or vice versa. Those things that the newly created money is spent first will rise first. This is associated with the demand structure within the society. When prices of goods and services rise, consumers face a loss in the purchasing power of the money and thus will demand higher wages. In Germany, strong pressure has been exerted by the labour unions to demand higher wages. Higher wages only alleviate the problem of insufficient income for the employees in the short term. In the medium and long term, the higher buying power of the households will lead to even higher prices down the road. This phenomenon is called the wage-price spiral.

Chart 2 highlights the development of the consumer price level and the increase in the money supply. Please note the tight correlation between money supply and consumer price increase. Under the Reagan administration following through to the Clinton and Bush administration, the statistical inflation measures had been changed to reduce the measured rate of inflation. The core inflation rate reported since the Reagan administration excludes for example “volatile” categories such as food and energy.⁶ The purple graph (CPI-U, same) illustrates the official figure reported by the Bureau of Labor Statistics in the U.S. The black graph is calculated as it used to be with the traditional calculation methodology. Note the distinct divergence emerging as early as the 1980s.

Chart 2: The money supply and price inflation⁷

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When governments, central banks or commercial banks begin inflating, the “new money” always finds a home and will either flow into goods and services or assets. Only the preferences of the disposer of the money affect which category will rise higher in percentage terms.

2.2 Asset inflation

The most predominant assets used as a store of wealth are real estate, bonds, other currencies and stocks. Contrary to price inflation where the consumer gets hurt, in asset inflation when stock markets or real estate rise, everybody engaged in those sectors feels more prosperous. This effect is called the “wealth effect”. A consequence of this effect is that people spend more and save less while feeling wealthier. In other words, asset inflation is often referred to as the “good inflation” although there are no overall positive effects of asset inflation since it distorts the market and misleads entrepreneurs and investors. In the 1990s, stock markets rose beyond the value of companies to earn profit. The enrichment of many people engaged in the stock markets was not wealth created through the means of production. It was inflated wealth created through too much money chasing too few goods or assets driving up their price.⁸ Chart 3 depicts a long term chart of the Dow Jones Industrial Average from the U.S. in nominal terms. Although stock prices in nominal terms look ballooned, an inflation adjusted chart of the Dow Jones would provide a more moderate picture.

The great economist of the Austrian School of Economics Ludwig von Mises states that it is absurd to pursue monetary inflation via credit expansion without making stock prices rise.⁹

Chart 3: The Dow Jones Industrial Average from 1928-2008¹⁰

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[...]

¹ see: http://www.etymonline.com/index.php?term=inflation.

² see: “Human Action” by Ludwig von Mises (1949), pp. 422-424.

³ see: “Human Action” by Ludwig von Mises (1949), pp. 398-399.

⁴ see: http://www.nowandfutures.com/key_stats.html#m3b.

⁵ see: “Making Economic Sense” by Murray Rothbard (2006), pp. 317-319.

⁶ see: “The politics of deception” by Tony Allison (2008).
http://www.financialsense.com/Market/allison/2008/0707.html.

⁷ see: http://www.nowandfutures.com/key_stats.html#gdp_money.

⁸ see: “Good and Bad Inflation” by Jim Publava (2003). http://www.financialsense.com/Market/puplava/2003/1117.html.

⁹ see: “Human Action” by Ludwig von Mises (1949), p. 796.

¹⁰ see: http://www.visualizingeconomics.com/wp-content/uploads/DJIA_History.png.