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Is Inflation about General Increases in Prices?

Mises Daily: Tuesday, March 13, 2012 by

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There is almost complete unanimity among economists and various commentators that inflation is about general increases in the prices of goods and services. From this it is established that anything that contributes to price increases sets in motion inflation. A fall in unemployment or a rise in economic activity is seen as a potential inflationary trigger. Some other triggers, such as rises in commodity prices or workers' wages, are also regarded as potential threats.

If inflation is just a general rise in prices as the popular thinking has it, then why is it regarded as bad news? What kind of damage does it do?

Mainstream economists maintain that inflation causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources. Inflation, it is argued, also undermines real economic growth.

Why should a general rise in prices hurt some groups of people and not others? Or how does inflation lead to the misallocation of resources? Why should a general rise in prices weaken real economic growth? Also, if inflation is triggered by various factors such as unemployment or economic activity then surely it is just a symptom and therefore doesn't cause anything as such.

To ascertain what inflation is all about, we have to establish its definition. Now, to establish the definition of inflation we have to establish how this phenomenon emerged. We have to trace it back to its historical origin.

The Essence of Inflation

Inflation originated when a country's ruler, such as a king, would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,

More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of "pounds" or "marks," but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.

Because of the dilution of the gold coins, the ruler could now mint a greater number of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.

The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about. As a result of the increase in the number of coins that masquerade as pure gold coins, prices in terms of coins now go up (more coins are being exchanged for a given amount of goods).

Note that what we have here is an inflation of coins, i.e., an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself). Also note that the increase in prices in terms of coins comes because of the coin inflation. Observe however that it is the increase in coins brought about by the dilution of gold coins that enables the diversion of resources here to the ruler and not an increase in prices as such.

Under the gold standard, the technique of abusing the medium of exchange became much more advanced through the issuance of paper money unbacked by gold. Inflation therefore means an increase in the number of receipts for gold because of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.

The holder of unbacked receipts can now engage in an exchange of nothing for something. As a result of the increase in the number of receipts (inflation of receipts) we now also have a general increase in prices. Observe that the increase in prices develops here because of the increase in paper receipts that are not backed up by gold. Also, what we have is a situation where the issuers of the unbacked paper receipts divert real goods to themselves without making any contribution to the production of goods.

In the modern world, money proper is no longer gold but rather paper money; inflation in this case is an increase in the stock of paper money.

Observe that we don't say, as monetarists are saying, that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.

Note that increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price rises as such.

Real incomes of wealth generators fall, not because of general rises in prices, but because of increases in the money supply. When money is expanded, i.e., created "out of thin air," the holders of the newly created money can divert goods to themselves without making any contribution to the production of goods.

As a result, wealth generators who have contributed to the production of goods discover that the purchasing power of their money has fallen, because there are now fewer goods left in the pool — they cannot fully exercise their claims over final goods, because these goods are not there.

Once wealth generators have fewer real resources at their disposal, this is obviously going to hurt the formation of real wealth. As a result, real economic growth is going to come under pressure.

General increases in prices, which follow increases in money supply, only point to an erosion of real wealth. Price increases by themselves however do not cause this erosion.

Likewise it is monetary inflation, and not increases in prices, that erodes the real incomes of pensioners and low-income earners. As a rule, they are the last receivers of money, often called the "fixed-income groups."

According to Rothbard,

Particular sufferers will be those depending on fixed-money contracts — contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long-term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are "taxed."

Can Inflation Emerge While Prices Stay Unchanged?

Now, all other things being equal, if for a given stock of goods an increase in the money supply occurs, this would mean that more money is going to be exchanged for a given stock of goods. Obviously, then, the purchasing power of money is going to fall, i.e., the prices of goods are going to increase (more money per unit of a good). In this case the general increase in prices is associated with inflation, i.e., increases in paper money.

But now consider the following case: the rate of growth in money is in line with the rate of growth in goods. Consequently, the prices of goods on average don't change. Do we have inflation here or don't we? For most economists, if an increase in the money supply is exactly matched by the increase in the production of goods, then this is fine, because no increase in general prices has taken place and therefore no inflation has emerged. We suggest that this way of thinking is false: inflation has taken place, i.e., the money supply has increased. This increase cannot be undone by the corresponding increase in the production of goods and services.

For instance, once a king has created more diluted gold coins that masquerade as pure gold coins he is now able to exchange nothing for something irrespective of the rate of growth of the production of goods. Regardless of what the production of goods is doing, the king is now engaging in an exchange of nothing for something, i.e., diverting resources to himself by paying nothing in return. This diversion is possible because of the increase in the number of coins brought about by the dilution of gold coins, i.e., the inflation of coins.

The same logic can be applied to paper-money inflation. The exchange of nothing for something that the expansion of money out of "thin air" sets in motion cannot be undone by an increase in the production of goods. The increase in money supply — i.e., the increase in inflation — is going to set in motion all the negative side effects that money printing does, including the menace of the boom-bust cycle, regardless of the increase in the production of goods.

According to Rothbard,

The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.

Does an Increase in Commodity Money Cause Inflation?

Now, let us say that on a gold standard, because of an increase in the production of gold, the supply of money — i.e., gold — has increased. Subsequently a general increase in the prices of goods has taken place. Should we label this increase as inflation? According to some commentators on the gold standard, an increase in the supply of gold generates similar distortions that money out of thin air does.

Let us start with a barter economy. John the miner produces ten ounces of gold. The reason he mines gold is because he believes there is a market for it. Gold contributes to the well-being of individuals. He exchanges his ten ounces of gold for various goods such as potatoes and tomatoes.

Now people have discovered that gold, apart from being useful in making jewelry, is also useful for some other applications. They now assign a much greater exchange value to gold than before. As a result, John the miner can exchange his ten ounces of gold for more potatoes and tomatoes.

Should we condemn this as bad news because John is now diverting more resources to himself? No, what is happening with John the miner is just what is happening all the time in the market. As time goes by, people assign greater importance to some goods and diminish the importance of other goods. Some goods are now considered as more important than other goods in supporting people's lives and well-being.

Now people have discovered that gold is useful for another use: to serve as the medium of exchange. Consequently they further lift the price of gold in terms of tomatoes and potatoes. Gold is now predominantly demanded as a medium of exchange — the demand for other services of gold, such as ornaments, is now much lower than before.

Note however, that gold is a part of the pool of real wealth and promotes people's lives and well-being. Let us see what happens if John increases the production of gold.

One of the attributes for selecting gold as the medium of exchange is that it is relatively scarce. This means that a producer of a good who has exchanged this good for gold expects the purchasing power of his effort to be preserved over time by holding gold.

If for some reason there is a large increase in the production of gold, and this trend persists, the exchange value of the gold will be subject to a persistent decline versus other goods, all other things being equal. Under such conditions, people are likely to abandon gold as the medium of the exchange and look for other commodity to fulfill this role.

As the supply of gold starts to increase, its role as the medium of exchange diminishes, while the demand for it for some other usages is likely to be retained or increase. So in this sense the increase in the production of gold adds to the pool of real wealth.

When John the miner exchanges gold for goods he is engaged in an exchange of something for something. He is exchanging wealth for wealth. Also note that an increase in the supply of gold didn't occur because of an act of diluting gold but because of an increase in gold production.

Contrast all this with the printing of gold receipts, i.e., receipts that are not backed 100 percent by gold. This sets a platform for consumption without making any contribution to the pool of real wealth. Empty certificates set in motion an exchange of nothing for something, which in turn leads to the misallocation of resources and to boom-bust cycles.

Remember, an increase in the supply of mined gold doesn't lead to the misallocation of resources, i.e., employment of resources contrary to the true free market, which reflects consumers' most urgent preferences. Note again that the number of coins increased here is not because of the dilution of gold coins but as a result of an increase in the production of gold, i.e., real wealth. In contrast to the holder of money out of thin air, the wealth generator — the gold producer — supports his own activities. He is not engaged in the diversion of real resources from other wealth generators by means of empty money. Consequently, any decline in the amount of money out of thin air is not going to hurt him. (Note a decline in the money out of thin air will reduce the diversion of resources to activities that emerged on the back of money out of thin air.)

Conclusion

Contrary to the popular definition, inflation is not about general rises in prices but about increases in money "out of thin air." Inflation is an act of embezzlement. On a gold standard, inflation is about the increase in receipts unbacked by gold money. On a paper standard, inflation is about an increase in the supply of paper money. The general increase in prices, as a rule, develops on account of the increase in money. The harm that most people attribute to rises in prices is in fact due to increases in the money supply out of thin air. Therefore, policies that are aimed at fighting inflation without identifying what it is all about only make things much worse. When inflation is seen as a general increase in prices, then anything that contributes to price increases is called inflationary. It is no longer the central bank and fractional-reserve banking that are the sources of inflation, but rather various other causes. In this framework, not only does the central bank have nothing to do with inflation; on the contrary, the bank is regarded as an inflation fighter.

On this subject Mises wrote,

To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.