There is almost complete unanimity among economists and various commentators that inflation is about general increases in the prices of goods and services. It is also held that to counter general increases in prices, as depicted by the consumer price index the CPI, the central bank should raise interest rates. A tighter interest rate stance by the central bank will “cool off” the demand for goods and services. This, in turn, is likely to weaken the growth rate of the consumer price index (CPI).
What Inflation Is
In order to counter “inflation,” there is the need to ascertain an accurate and precise definition of inflation. In reality, inflation is the act of the diversion of wealth by means of an artificial expansion of the money supply. Historically, inflation originated when a country’s ruler would force his citizens to give him all of 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 gold alloy coin. The increase in the number of coins brought about by this debasement of gold coins is what inflation is all about (i.e., the increase in the number of coins).
If we were to accept that inflation is an increase in the money supply, then we are likely to reach the conclusion that inflation results in the diversion of wealth from wealth-generators towards the holders of newly-printed, coined, or digitally-created money. We are also likely to conclude that the increase in money supply (i.e., inflation) is bad for the wealth-generating process.
What is today called “inflation” is a general increase in prices, which is, in fact, a consequence of inflation. Consequently, anything that contributes to price increases is labeled inflationary and therefore must be guarded against. Thus, a fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and, therefore, must be restrained by central bank policies. Some other triggers such as increases in commodity prices or workers’ wages are also regarded as potential threats and, therefore, must always be under the watchful eye of the central bank policymakers.
High Interest Cannot Undo a Previous Policy of Artificially-Low Interest
Can a tight interest rate stance by the central bank undo the damage of the easy money stance stance? The misallocation of resources because of the easy interest rate policy cannot be reversed by a tighter stance as such. A tighter interest rate stance, while likely to undermine activities that emerged because of inflationary increases in money supply, is also likely to generate various distortions, thereby inflicting damage to wealth-generators. A tighter stance is still intervention by the central bank and, in this sense, it does not result in the allocation of resources in line with consumers’ priorities.
According to Percy L. Greaves,
Mises also refers to the fact that deflation can never repair the damage of a priori inflation. In his seminar, he often likened such a process to an auto driver who had run over a person and then tried to remedy the situation by backing over the victim in reverse. Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.
High Interest versus Closing Monetary Loopholes
Let us contrast a tight interest rate policy to counter general increases in prices (erroneously labeled “inflation”) with a policy that closes the loopholes of the money supply expansion. (For instance, the central bank is not allowed to monetize the government budget deficit). The policy of curbing money supply increases will undermine bubble activities (i.e., activities that emerged due to previous increases in money supply). This will arrest the diversion of wealth from wealth-generators to bubble activities.
Again, such a policy is great news for wealth-generators since less wealth is taken from them. This, in turn, is likely to result in the expansion of private savings. This expansion is also likely to shorten the period of the economic slump and also make the slump less severe. By employing an erroneous definition of inflation, Fed policymakers end up attacking the symptoms rather than the causes of inflation. As a result, they make things much worse. According to Mises,
Inflation, as this term was always used everywhere and especially in this country, means increasing the quantity of money and bank notes in circulation and the quantity of bank deposits subject to check. But people today use the term “inflation” to refer to the phenomenon that is an inevitable consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been, up to now, called inflation.
For most commentators, inflation is about persistent increases in the consumer price index (CPI). But the essence of inflation is not a general rise in prices but artificial increases in the supply of money and credit, which, in turns, sets in motion a general increase in the prices of goods and services.
To counter price inflation what is required is to curb increases in money supply and not increases in the prices of goods and services. By curbing increases in money supply, the impoverishment of wealth-generators is going to be curbed too. This will revitalize the economy by reducing the embezzlement of wealth-generators.
Conclusion
A tighter interest rate stance by the central bank undermines not only bubble activities but also wealth-generating activities. This only prolongs the economic slump. Instead, a true monetary interest rate—based on the interplay of supply and demand, individual time preferences, and private saving—is required.
If the central bank were to focus on true inflation, the effects of curbing the monetary growth rate would allow the removal of bubble activities and the strengthening of wealth-producers. Consequently, this is likely to shorten the period of the economic slump and make it milder.
