Inflation, defined as an expansion of the supply of unbacked money, is an elementary evil, always and everywhere that it occurs. It is the ignored and core cause of numerous problems in the economy and in society, including:
1. Inflation Causes Booms and Busts
Increasing the money supply that involves the granting of more credit means that new money is created by credit that is not covered by savings. This causes interest rates to fall more than would be the case without an expansion of the money supply. The result is an artificial economic boom, which politicians and the general public initially welcome. Investments are triggered that would not have been carried out if the invested capital had to be saved up first, prior to such investments. Therefore, there are insufficient resources available to bring all the projects thus begun to completion. In addition, resources – which are by their very nature scarce – are not brought to bear where they are most needed – in the most urgent projects. When interest rates climb again, the malinvestment comes to light, and a crisis – a bust – results. To overcome the bust, the central bank then reduces the interest rate again. A crisis that would clean things up is thus not allowed to happen, because it is politically undesirable.
2. Inflation Redistributes Wealth and Purchasing Power
An un-backed expansion of the money supply causes the prices of goods and services to rise. The parties who first receive the newly created money profit. They are able to make purchases at goods prices that still have not risen, whereas the later recipients of the money will only enjoy the benefits of the new money when the goods prices have already risen. They are put at a disadvantage and lose relative to the initial recipients of the cash. In addition, some market participants don’t gain anything from the newly created money. The initial recipients are the banks, the state, and large enterprises. This effect also occurs when the price of goods remains stable due to money expansion and would otherwise have fallen without an expansion of the money supply. In this instance, inflation is particularly nefarious.
This post was published at Ludwig von Mises Institute on Monday, September 08, 2014.