Is Inflation Ever Good for a Nation
What is Inflation?
June 28, 2011
Inflation is never good for a nation. Inflation causes prices to rise on all goods and services in the economy which makes it more expensive for people to buy things.
From the perspective of an individual, inflation is no different than a pay cut in that, with inflation, the money that one receives in their paycheck buys less than it did before.
In fact, since inflation, once it gets going, tends to keep increasing the effect is more like a reduction in pay each pay day in that each paycheck buys fewer and fewer goods.
Economists use the terms nominal income and real income to differentiate between the dollars (or other unit of currency) one receives in their paychecks and the value of the goods those dollars will actually buy.
Nominal income refers to the actual number of dollars one received as their pay. This figure is generally constant for most people as those on a salary are paid a fixed amount each payday while those paid on an hourly or commission basis will tend to receive the same dollar amount of pay as their hours worked or sales generally remain somewhat constant.
Real income is a person’s nominal income adjusted for inflation (or deflation). This is what the dollars in a paycheck will actually buy. With inflation those relatively constant dollars received each pay day will buy less and less as the prices of goods and services keep rising.
Looked at it this way, as a cut in people’s pay, inflation is not good.
What is Inflation?
Before going further let me define what inflation is and what causes inflation to occur.
There are actually two definitions of inflation.
The first is the classical definition which is basically an increase in prices throughout the economy resulting from an increase in the money supply, or amount of money in circulation, by the government.
The second is favored by politicians and Keynesian economists and that is any increase in overall prices (the price level) in the economy.
This second definition is broader and encompasses both inflation resulting from an unneeded increase in the money supply as well as increases in prices due to a price increase in a product that is used in the production of many other goods in the economy.
Inflation Resulting From an Increase in the Money Supply
Historically, inflation has usually resulted from governments either debasing metallic (gold or silver) coins by mixing the gold or silver with a cheaper base metal or by printing paper money in large quantities. Today, most nations increase the money supply by having their government controlled central bank inject additional reserves into the banking system.
This has the effect of enabling the banks to make more loans thereby increasing the amount of money in circulation.
Any way inflation is accomplished, the result of creating more money, metal, paper or electronic, than the amount of existing goods in society produces inflation.
Continuing to create money in this manner results in increasing the inflation rate and, if continued long enough the increasing rate of inflation will lead to hyper inflation, a situation where money is worth less than the paper it is printed on.
Inflation Resulting from an Increasing Price Level
Economists use the term price level to describe the overall level of prices in an economy. A rising price level means that prices of all or most goods and services are increasing. A falling price level means that prices in general are decreasing.
While increasing the money supply will result in a rising price level, other things can also cause this.
Demand Pull Inflation
Demand Pull Inflation is a term, usually associated with Keynesian economics, that is used to describe a rise in the price level resulting from an increase in aggregate demand. Aggregate demand refers to total demand for all goods and services in the economy.
This increase in the price level caused by an increase in aggregate demand can be caused by a number of things which include:
- an increase in the money supply which provides consumers, business and government more money to spend and this increase in spending causes an increase in aggregate demand.
- an increase in spending by consumers, business or government as a result of growth induced rising incomes and/or easier access to credit.
- an increase in exports where by foreigners begin purchasing larger quantities of the economy’s output thereby reducing the domestic aggregate supply.
So long as there are unemployed resources (resources being land, labor, capital and entrepreneurship) the increase in aggregate demand will be met with an increase in output and incomes (real Gross Domestic Product or GDP) which will moderate the price increases.
However, when resources are fully employed, further increases in aggregate demand will result in rapidly rising prices. Left alone, the economy will readjust as the rising prices cause increasing numbers of domestic and foreign consumers to cut back on purchases thereby slowing the rate of growth and decreasing aggregate demand. Also, as costs and interest rates rise, producers will start reducing their purchasing and expansion activities.
In the long run, increased investment in labor saving equipment will enable workers to be more productive as will advances in technology and more efficient production processes.
Outsourcing of labor intensive production to areas with a labor surplus as well as increased immigration will reduce labor shortages (increased births will also do this, although it takes about 20 years before newborns enter the labor force).
Cost Push Inflation
Cost Push Inflation is another term associated with Keynesian economics which refers to the price level rising due to the increase in one or more critical resources. The resources in question are usually rising labor costs across the economy or rapidly rising costs for a natural resource such as oil or food.
Strong economic growth will often result in a reduction in the supply of labor as growing demand for workers by employers seeking workers as they increase their output.
Other factors that can reduce the supply of labor, thereby driving up wages overall, can be unions which act, usually with the backing of government, as cartels to artificially limit the supply of labor.
War may also reduce the supply of labor as the government, either voluntarily or through conscription, mobilizes much of the available manpower for military duty. This reduction may be short term if the war is short and casualties light or long term in the case of a long war and/or heavy casualties.
While not common today, plagues, such as the Black Plague during the Middle Ages, have resulted in a big reduction in the supply of labor causing wages to rise.
The supply of other critical resources such as oil or food can also be reduced due to war, natural disasters or the formation of cartels (think OPEC) can cause a reduction in the supply of and the increase in prices of these resources to occur.
Oil is especially critical in today’s world as it is a main energy source used in all phases of production. As the price of oil increases, producers throughout the supply chain find themselves paying more for both oil for energy as well as more for other inputs that consumed energy in their production.
These increased prices are passed on during each stage of production resulting in rising prices throughout the economy.
Like most instances of demand pull inflation, the cause of cost push inflation is the market’s response to shortages. And, just as the market, if left to itself, will adjust to these changes and work itself out in the case of demand pull inflation it will also work itself out in the case of cost push inflation.
Unfortunately, government policies are often not only responsible for the cause of the cost push inflation, they also often make the problem worse by attempting to ease the problem by increasing the money supply in an attempt to off set the price rises.
Moral Problems with Inflation
Inflation is both an economic problem and a moral evil.
While inflation is never good for the economy as a whole, it can, in its early stages at least, benefit certain groups within the economy. This benefit for certain groups however, comes at the expense of others in the economy.
Like theft, which is what inflation is really all about, in which the thief gains wealth but at the expense of the victim, inflation also transfers wealth from one group to another.
Some examples of this wealth transfer are:
- Self employed Professionals can often increase their incomes to keep up or stay ahead of inflation thereby gaining or at least not suffering from inflation in its initial stages.
- Regular employees whose wages are fixed by their employer or by union contracts that fix wages for a year or more. In the past unionized workers whose hard won union contract guaranteed them a good wage often saw the value of that wage shrink as inflation set in.
- Borrowers gain because they are able to repay their loans with money that is worth less than the money they borrowed.
- Lenders are hurt as the value of their loans are being repaid with cheap money whose purchasing power is less than the purchasing power of the money originally loaned.
While many people look upon this as the poor little guy or common man vs the the wealthy bank, the truth is that the money the bank has to lend comes from similar poor little savers who have been salting part of their earnings away for retirement, a vacation, a new home, an emergency, etc in their bank accounts.
The wealth transfer here is from the average citizen who saves to the average citizen who borrows. Normally, there is nothing wrong with being a borrower or saver as each benefits from the actions of the other.
However, inflation perverts this normally mutually beneficial relationship into a form of theft.
- A big beneficiary, again in the early stages of inflation, is politicians and government. Since ancient times unscrupulous rulers have used inflation to advance government wealth at the expense of their people.
Governments and politicians often see inflating the money supply as a way to increase spending without having to raise taxes.
The effect of inflation on people’s incomes is the same as taxes as it reduces their spending power the same as taking the money directly in the form of taxes. It is the same for the government as well as it has more money to spend.
The big difference is that inflation does this by stealth rather than directly as with taxes, thus making it more difficult for voters to associate their decline in income with the officials at election time.
Political & Economic Problems With Inflation - Hyperinflation
In addition to the economic and moral problems described above there is the danger that inflation will continue to expand until it becomes a deadly hyperinflation.
With hyperinflation, paper money is less than worthless with the paper the money is printed on having more value that the monetary value printed on it.
With hyperinflation, not only does the economy and normal commercial transactions break down but society and the government also often fall.
While there have been a number of instances of hyperinflation in recent centuries, the classic case of ruinous hyperinflation is the German Wiemar Republic that was established to govern Germany following World War I and the abdication of Kaiser Wilhelm II.
In the aftermath of the war Germany was broke and its economy in shambles. The new government attempted to solve its financial problems by printing money which led to inflation. The printing continued and soon the country was in the midst of a severe hyperinflation.
The situation was so bad that it literally took bags of high denomination bills to purchase every day goods. The bills themselves were usually worthless shortly after they were printed and there are photos from that era showing people burning notes in stoves to heat their homes as the paper notes were more valuable as fuel than as money.
Other photos depict people using large denomination bills to paper their walls or to use as note paper to write on. Again, it was less expensive to use the money itself for these things than to attempt to purchase things like firewood, wall paper, note paper, etc.
Most historians today cite the economic and political destruction in Germany caused by the hyperinflation as a major reason for the coming to power of Adolph Hitler and his Nazis.
People Acting to Protect Themselves Against Inflation
Interestingly, following World War II, Germany, with its people having bitter memories of the past hyperinflation, pursued sound money policies and avoided many of the Keynesian policies, which favored a certain amount of inflation, that the United States and other Western European nations followed.
As a result, Germany did not suffer the serious inflation (which fortunately did not reach hyperinflation proportions) that the United States and most West European nations endured in the decades following World War II.
With their bitter memories of their sufferings during the hyperinflation during the Weimar Republic years, the German people were quick to react to any hint of pending inflation by taking steps to protect themselves economically in the market and by threatening action against sitting politicians at the polls.
Being a form of theft based upon deceit, inflation only works for governments when they can make people believe the inflated money they are producing is real. Once people are on to this and take protective action, such as moving to gold or so called hard currencies (which are currencies of other nations whose currencies are not inflated), etc.
While such actions will not stop an out of control hyperinflation once it starts, the threat of such actions will prevent rulers from benefiting from starting to inflate their currency and, by not being able to use inflation to solve a short term problem, rulers will be less likely to turn to inflationary policies as a solution to problems the government is facing.
© 2011 Chuck Nugent