The benefit to politicians of continuing to inflate the money supply is that, by delaying the discovery of the need to scale back over-expanded industries, they keep the economy appearing for a while longer to be healthier than it really is. These politicians, therefore, are at less risk of losing their jobs in the next election.
Economic reality, however, cannot forever be masked by the mere printing of more and more money. As the earlier streams of newly created money work their way through the economy to cause the prices of all goods and services to rise, inflation becomes expected. So for prices in the over- expanded industries to continue to be read by investors and entrepreneurs as signals that the increased investments in these industries are really not excessive, prices in these industries must rise even faster than before. Prices in these industries must rise at a pace greater than the expected rate of inflation.
To cause prices in these industries to rise faster than the economy’s general rate of inflation, the central bank must quicken the pace at which it injects new money into the economy. If the central bank does so, prices in the industries that are first in line to get newly created money will remain higher than they “should” be relative to prices in other industries. Entrepreneurs and investors might then continue for the time being to believe that their increased investments in these “first-in-line” industries are justified. Efforts to scale back these industries are postponed. The unemployment rate, which would have risen today had there been no increase in the rate of monetary expansion, remains low. All looks well—for the present.
Eventually, however, the faster rate of money injection inevitably results in a faster rate of economy-wide inflation. Prices throughout the economy are now rising at a pace to catch up with the rising prices in those industries that are among the first to receive the newly created money. As a consequence, prices in these “first-in-line” industries stop sending out misinformation. These prices begin to reveal the fact that investments in these industries are indeed excessive—that productive capacity in these industries is too large. And so the only way the monetary authority can prevent investors from scaling back these industries and from laying off workers is to ramp up even more the rate of monetary expansion.
The monetary authority soon finds itself in a difficult spot. If it stops inflating the money supply (indeed, even if it simply fails to accelerate the rate of growth in the money supply), the industries that over-expanded because of earlier injections of new money will contract. The resulting rise in unemployment creates political pressures for government to “do something” to raise employment—something other than counseling the public to patiently wait while industries are restructured to be more economically sustainable. Accelerating the rate of inflation is one maneuver the government can take to keep employment high for the present.
But the increasing rate of monetary expansion leads to an increasing rate of inflation, which causes a host of other economic ills. These other ills include rising interest rates. (Bankers and other lenders will charge higher interest rates because they expect to be repaid next year in money of lower purchasing power than is the money they lend out today.) The other ills also include greater anxiety among workers that their wages will not keep pace with inflation—so workers demand higher wages today, ahead of the expected higher inflation. (The danger here is that if the rate of inflation turns out to be less than expected, workers’ wages will have risen too high, causing some workers to lose their jobs or some employers to suffer unexpected losses.)
More generally, because monetary expansion does not cause all prices to rise in lock-step with each other, the higher the rate of inflation, the more distorted becomes the pattern of relative prices throughout the economy. The more out of whack individual prices become relative to each other, the less reliably do these prices guide entrepreneurs, investors, and consumers to make correct economic decisions. Higher rates of inflation, therefore, result in greater misuse (greater “misallocation”) of resources. The economy’s performance becomes worse and worse.
To cure this problem the monetary authority need only to stop injecting new money into the economy. But the cure isn’t instantaneous. Not only does it take some time for people to stop expecting future inflation, but, also, it takes time for workers and resources to shift away from industries that overexpanded because of inflation and toward industries where these workers and resources will be more sustainably employed. By continuing inflation today, the monetary authority might be able to delay just a bit longer the need for over-expanded industries to shrink, but doing so also causes inflation throughout the economy to worsen.