Is Higher Inflation Inevitable?
In view of the ongoing international financial and economic "crisis," many investors increasingly ask, Is higher inflation inevitable?1 At first glance, this question appears to be rhetorical. Technically speaking, inflation can of course be prevented.
Inflation is, in the economic sense, an increase in the money supply, which leads (and necessarily so) to a decline in the purchasing power of money as compared to a situation in which the money supply remains unchanged.
Today, government-sponsored central banks hold a money-production monopoly. So all it takes to end (and prevent) inflation is for central banks to stop expanding the money supply.
At second glance, however, the question of whether higher inflation is inevitable may be somewhat more difficult to answer. This is because of the economic and political consequences that ending decades-long increases in the money supply through central banking will entail.
A world monetary system has emerged that has no historical precedent: a system in which every major currency in the world is … on an irredeemable paper money standard.2
And further, "The ultimate consequences of this development are shrouded in uncertainty."3
Friedman draws our attention to the fact that today's monies — be they the US dollar, the euro, the Chinese renminbi or the British pound — are so-called fiat monies, with the term fiat ("let it be done" in Latin) denoting intrinsically valueless money.
Fiat money (some call it paper money, or political money) has three major characteristics. First, it is produced under monopoly power held by the government-sponsored central bank.
Second, fiat money is typically created through bank-credit expansion. Whenever extending credit to firms, private households, and government, banks increase the stock of money. In that sense, today's fiat money is credit money.
And third, fiat money causes (and inevitably so) economic disequilibria — the notorious boom-and-bust cycles — and the rise of overall debt exceeding the growth of incomes. These aspects will be explained in more detail below.
For many great thinkers, fiat money has a bad rap. For instance, the view that "paper money eventually returns to its intrinsic value — zero" is typically attributed to the French philosopher Voltaire (1694–1778).
is peculiarly liable to be the subject of political intrigue and of popular misunderstanding. It is this danger, more than anything else, that makes political money in general a poor kind of money.4
Against these manifold warnings it appears particularly remarkable that fiat monies have been established the world over, and that fiat money is even widely seen these days as a state-of-the-art monetary regime.
Economists of the Austrian School hold a rather different view, though. Their work deserves particular attention in this context, as they have developed perhaps the most detailed theory of the role of fiat money for the trade cycle, inflation, and political developments.
They found that the injection of fiat money through bank credit expansion6 lowers the market interest rate to below the natural rate level — as the Swedish economist J.G. Knut Wicksell (1851–1926) called it — that is, the interest rate that would prevail had the credit and money supply not been artificially increased.
The artificially suppressed interest rate makes firms increasingly shift scarce resources into more time-consuming production processes for capital goods at the expense of production processes for consumer goods, causing intertemporal distortions of the economy's production structure, leading to malinvestment.
Fiat-money injection increases consumption out of current income at the expense of savings, and, in addition, leads to higher investment, so that the economy enters an inflationary boom, living beyond its means.
If the injection of fiat money created through bank-circulation credit out of thin air were a one-off affair, it presumably wouldn't take long for the artificial boom to unwind. A recession would restore the economy to equilibrium as people returned to their truly desired consumption-savings-investment relation (as determined by time preference).
In a fiat-money regime, however, increases in credit and money are not a one-off affair. As soon as signs of recession appear on the horizon, public opinion calls for countermeasures, and central banks try their best to "fight the crisis" by increasing the fiat-money supply through bank-circulation-credit expansion, thereby bringing interest rates to even lower levels.
In other words, monetary policy — usually to the great applause of mainstream economists — fights the correction of the problem by recourse to the very action that has caused the debacle in the first place.
Such a strategy cannot be pursued indefinitely, though. When credit expansion comes to a shrieking halt — that is, when banks refrain from lending — the inevitable adjustment unfolds. Borrowers default, and firms liquidate unsound investments and cut jobs.
And the longer an artificial credit-money boom had been kept going through repeated credit-produced fiat-money injections, the greater will be the malinvestments that must be corrected, and the higher will be output and employment losses.
This is so because repeated injections of fiat money through bank-circulation-credit expansion have two consequences. First, they prevent unprofitable investments from being liquidated. Instead, lower interest rates seemingly return unprofitable investment to profitability, as they can be refinanced at lower interest rates.
Second, the artificially suppressed interest rates encourage additional investments — investments that would not have been undertaken if the market interest hadn't been pushed downward by central-bank actions.
As a consequence, the economy's overall debt load keeps growing at a faster rate over time than real incomes do, leading to a situation of overindebtedness. This process is of course accompanied by the piling up of massive government debt, which is particularly easy to finance in a fiat-money regime.
Mises knew that pushing interest rates down to ever-lower levels would not solve the problem, but instead would lead to even bigger problems:
There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.7
Mises's lines imply both (hyper)inflation and deflation as the potential outcomes of a fiat-money collapse. (Hyper)inflation would result if government tries to "print itself out of the mess" it has created, and deflation from a contraction in the money supply as banks call in outstanding loans and/or default on their obligations, thereby destroying (part of) the fiat-money stock.
If one subscribes to the diagnosis provided by the Austrian School of economics, two important observations must be made. First, issuing more bank-circulation credit and fiat money at even-lower interest rates will not, and cannot, solve the problem that has been caused by monetary expansion in the first place.
Second — and this aspect may not attract attention right away — governments' ongoing attempts to fight the economic correction by recourse to interventionist policies (such as regulation, prohibitions etc.) will increasingly undermine the free-market order.
This is something that cannot, and should not, be taken lightly, as free markets are at the heart of economic prosperity. Free markets allow for productive and peaceful economic cooperation nationally and internationally. Suppressing them would therefore come at a fairly heavy price.
The severity of the ongoing international monetary crisis is epitomized perhaps best by a growing debate about monetary reform. For instance, the International Monetary Fund, in February 2011, called for a wide-ranging reform of the international monetary system.8
Back in November 2010, the president of the World Bank, Robert Zoellik, argued that a successor of what he calls "Bretton Woods II" would be needed:
The system should also consider employing gold as an international reference point of market expectations about inflation, deflation and future currency values.9
In March 2009, Zhou Xiaochuan, governor of the Peoples' Bank of China, wrote,
The desirable goal of reforming the international monetary system … is to create an international reserve currency that is disconnected from individual nations and is able to remain stable in the long run, thus removing the inherent deficiencies caused by using credit-based national currencies.10
In contrast to these concepts — which are, and unsurprisingly so, interventionist by nature — economists from the Austrian School have been putting forward recommendations and strategies for reforming the monetary system along free-market principles.
Their recommendations are driven by the insight that the great financial and economic crises are not inherent in capitalism, but result from government interventionism in monetary affairs, most importantly by monopolizing money production. Hayek put it succinctly in 1976:
The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.11
Austrian economists are of the opinion — based on elaborate economic-ethical considerations — that curing the current financial and economic crisis would require a return to sound money. By "sound money," they mean money that is compatible with the principles guiding the free-market economy.
Sound money is free-market money, money that is the result of the free supply of and the free demand for money. It is money that is produced in unhampered markets where there are no longer any legal privileges for, for instance, central banks.
As early as 1953, Ludwig von Mises argued for a return to sound money by reanchoring the US dollar to gold, based on a free-market price of gold vis-à-vis fiat money, and abolishing central banking. Mises favored a gold standard and 100 percent reserve banking.12
Hayek, in Denationalization of Money, argued that one could do even better than returning to gold, namely by allowing for a competition of currencies. According to Hayek, all legal-tender laws should be abolished, thereby allowing for money users free choice for their currency, supplied by producers free to supply money. The best money, or the best monies, so Hayek would say, would win out.
Murray N. Rothbard (1926–1995) argued, actually following Mises's reform concept, for a return to the gold standard by reanchoring fiat money to central-bank gold reserves — effectively by raising the price of gold in terms of fiat-money tickets so that it allows for 100 percent reserve banking.13
As things currently stand, the chances that the world monetary system will return to free-market money — such as a freely chosen gold standard without central banking — may appear small to many observers. This probably stems from a number of reasons.
Perhaps most important of these is that the prevailing ideology in today's mainstream economics has reduced the numbers of supporters who effectively make a case for sound money to a tiny group whose voice is easily lost, and consequently the public may not (yet) be fully aware what it has to gain from sound money.
In any case, finding an economically viable solution to the problem at hand is a challenge that the societies that have adopted fiat money will not, and cannot, escape.
One thing is certain: Escalating injections of fiat money into the economies is not a promising policy in terms of restoring the economies back to health. Such injections would just lead to further debasement of the currency without solving the underlying root cause of the problem.
What about the consequences of a market-oriented monetary reform? If government were to decide to reanchor fiat monies to gold, the outcome would be a debasement of the currencies if and when the price of gold is set at a level that results in a rise of the fiat-money stock — which would be, of course, a rather tempting decision to make if those in government hold the view that there is "too much" debt around.14
Alternatively, a substantial debasement — or even total erosion — of fiat money's purchasing power would result if and when the monetary reform is driven by unhampered market forces in the following way: people start increasingly to exchange their fiat money (which isn't redeemable into anything) for sound money media such as gold and silver, thereby driving down the exchange value of fiat money (even to the disappearing point).
A monetary reform (in one way or the other) is economically inevitable from the Austrian viewpoint — a fiat-money regime cannot be upheld indefinitely. As a result, one would have to conclude that the debasement of existing fiat monies has become almost inevitable.
- 1. This pressing question is certainly not new. For instance, Friedrich August von Hayek asked "Can We Still Avoid Inflation?" in a lecture given in New York on May 18, 1970, which was published in 1978. Hayek concluded, "If we are to avoid continued world-wide inflation, we need also a different international monetary system."
- 2. Milton Friedman, Milton Friedman, Money Mischief: Episodes in Monetary History, Harcourt Brace Jovanovich, New York, 1992, p. 249., Harcourt Brace Jovanovich, New York, 1992, p. 249.
- 3. Ibid.
- 4. Frank A. Fetter, Modern Economic Problems, 2nd ed., New York, The Century Co., p. 53.
- 5. Irving Fisher, The Purchasing Power of Money, Its Determination and Relation to Credit, Interest and Crises, New York: Macmillan, p. 78.
- 6. Mises made a distinction between bank circulation credit (Zirkulationskredit) and bank commodity credit (Sachkredit). The former denotes a credit through which the money stock increases, while the latter stands for credit through which existing money is transferred from the saver to the investor.
- 7. Ludwig von Mises, Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 572
- 8. "Toward a More Stable International Monetary System," opening remarks by Dominique Strauss-Kahn, International Monetary Fund, at the lecture and discussion "Towards a More Stable International Monetary System," Washington DC, February 10, 2011.
- 9. Robert Zoellick, "The G20 Must Look Beyond Bretton Woods II," FT.com, November 7, 2010.
- 10. Zhou Xiaochuan, Governor of The Peoples' Bank of China, "Reform the International Monetary System," Xinhua, March 26, 2009.
- 11. F.A. Hayek, Denationalization of Money, The Argument Refined, An Analysis of the Theory and Practice of Concurrent Currencies, The Institute of Economic Affairs, 3rd ed., p. 102.
- 12. Mises outlined this strategy in part four of the 1953 edition of his The Theory of Money and Credit, New Haven: Yale University Press. For further explanation see Jörg Guido Hülsmann (2008), "Mises on Monetary Reform: the Private Alternative," in: Quarterly Journal of Austrian Economics, 11, pp. 208–218.
- 13. See in this context Murray Newton Rothbard, Mystery of Banking, 2nd ed., Ludwig von Mises Institute, Auburn, US Alabama, pp. 261–268.
- 14. For a detailed discussion about setting the price of gold see George Reisman, Capitalism: A Treatise on Economics, Jameson Books, Ottawa, Illinois, pp. 959–962.