The curse of inflation Chapter 8

Even a very moderate degree of inflation is dangerous because it ties the hands of those responsible for policy by creating a situation in which, every time a problem arises, a little more inflation seems the only easy way out.

Friedrich Hayek (1960). The Constitution of Liberty.
In Ronald Hamowy (ed.),
The Constitution of Liberty, XVII
(Liberty Fund Library, 2011): 465.

Inflation is a decline in money’s purchasing power. Inflation’s most visible consequence is steadily rising prices of all or most goods and services in the economy. For a unit of money (say, a dollar) to lose purchasing power is for that unit of money to lose value. And when a unit of money loses value, it takes more units of that money to buy goods and services. In other words, the prices of goods and services bought with that money rise.

By far the most common cause of inflation is an increase in the supply of money. Just as the value of diamonds would fall if a freak meteorological event caused the skies to rain down genuine diamonds, the value of money falls when a nation’s monetary authority increases the supply of that nation’s money. Just as a rainstorm of diamonds would cause people who are willing to sell things in exchange for diamonds to demand more diamonds from buyers, an increase in the supply of money by the monetary authority causes people who are willing to sell things in exchange for dollars to demand more dollars from buyers.

The cause of inflation, therefore, is quite simple: excessive growth in the supply of money. Stopping inflation is likewise simple: quit injecting newly created money into the economy. But while stopping inflation is easy in principle (no complex theories must be mastered, and no intricate mathematical problems must be solved), it is often very difficult to stop in practice. The reason is that control of the money supply is in the hands of government officials. Stopping inflation is made difficult by politics, not least because it is politics that usually is to blame for starting inflation in the first place.

Since the demise of the gold standard in the twentieth century, governments have issued “fiat” money. Fiat money is money backed by nothing other than faith in the government that issues it. A government that issues fiat money will redeem units of that money only for other units of that money. The European Central Bank, for example, will redeem 20 euros only for 20 other euros. No gold, no silver, no anything other than itself backs fiat money.

One result of fiat money is to tempt government to finance some, and sometimes much, of its expenditures by creating money out of thin air. Because voters frequently and immediately resist having their taxes raised by enough to support every project that government officials want to fund—and because voters typically don’t see the ill-effects of newly created money until much later—government officials often succumb to the temptation to pay for some of their preferred projects with newly created money.

As we saw in the previous chapter, however, money creation by government can cause serious problems down the road. The process of injecting newly created money into the economy can distort the pattern of relative prices and, hence, encourage an unusually large number of faulty economic decisions—that is, encourage an unusually large number of economic decisions that are revealed only later to be mistaken. Specifically, injecting new money into the economy causes too many resources to be invested in those industries that first receive the new money. Those industries over-expand.

Trouble arises when the truth is revealed that these industries over-expanded. When this revelation occurs, investors and entrepreneurs begin to eliminate what they now see is excess capacity in these over-expanded industries. Efforts to shrink these over-expanded industries, though, inevitably cause hardships. Most notably, unemployment rises as workers are laid off from their jobs in these industries.

During the time that unemployment is unusually high—during the time that it takes for these laid-off workers to find new jobs—political pressure is intense for government to “do something” about this unemployment. One of the easiest “somethings” that government can do is to keep the inflation going. By continuing to inject new money into the economy, government can for a bit longer prop up prices in the industries that are among the first to get the new money. In short, by continuing to inflate the money supply, government can postpone the discovery by entrepreneurs and investors that the industries that are among the first to get the new money are in fact over-expanded and burdened with excess production capacity.