The wickedness of inflation and why it continues to be official policy

Whilst individuals have received a rude awakening of the problems that come with high inflation—namely being an increase in the cost of living—its ills stem far further than that.

Inflation has many pernicious qualities, including contributing to: an increase in speculatory activity and asset bubbles; encouraging excessive debt and living beyond one’s means; widening wealth inequality and delivering the hardest hits to those who can least afford it; and the misallocation of resources that later requires a painful economic correction.

Yet despite all of these problems, the very foundation of the world’s economic system, is by design, made to generate inflation.

An increase in speculatory activity and asset bubbles

In order to understand how inflation promotes speculatory activity and asset bubbles, one needs to understand how inflation is created, which is principally by increasing the money supply. When new money is printed, there is suddenly more money available to spend on a given good or service, increasing demand at first, and inflation later.

Inflation, and particularly high inflation caused by an artificial increase in the money supply, lags an increase in the money supply for reasons including: 1) it takes time for new money to flow throughout the economy and broadly raise demand; 2) it takes time for businesses to be confident enough that an increase in demand will be sustained, and that their business will benefit from raising their prices; and 3) some businesses that face particularly strong competition may wait until their input costs rise before raising their prices, which again, can take time given the time required for an increase in the money supply to flow throughout wide enough areas of the economy to generate such an increase in input costs.

Given that demand rises immediately, and prices change with a lag to increases in the money supply (and particularly so to large artificial increases in the money supply), such inflationary monetary policy can significantly stimulate an economy at first. Real income grows. Real demand grows. Employment grows. The entire economy seemingly benefits from a relatively sudden burst of demand. People become not just confident, but often exuberant.

This creates conditions that are ripe for not just the stock market to perform well, but also most other asset classes, with the influx of funny money causing a wide array of temporary distortions and unusual booms, with irrational exuberance eventually taking hold. Whilst many will point to the 2021 crypto market boom as forming the poster child for the speculative mania that engulfed markets as a result of the most recent surge in the money supply, let us not also forget the price action seen in even more obscure markets, such as in NFTs.  

Encouraging excessive debt and living beyond one’s means

Just as inflation encourages speculatory activity and asset bubbles, this phenomenon also feeds into taking on excessive debt and living beyond one’s means. For given that inflation acts to not only increase the prices of the goods and services we consume, but also asset prices over time, it encourages one to take out investment loans that are as large as possible (most commonly to purchase real estate), in order to magnify the benefit to one’s returns that financial leverage can bring.  

To illustrate, if I purchased a $500,000 home with a $300,000 mortgage, and inflationary monetary policy contributed to that homes value increasing by 10 per cent to $550,000, the return on equity (being the $200,000 of my own cash that was invested into the property) would be 25 per cent. If I instead purchased the same home with a $400,000 mortgage, meaning I only invested $100,000 of my own equity, my return on equity would have been 50 per cent. Given that this also works in reverse, whereby if prices fell by 10 per cent, one would have wiped out 50 per cent of their equity in the latter example, individuals are only encouraged to take on such leverage when under the expectation that prices will continue to rise, as is supported by an inflationary monetary policy framework.

The allure of maximising one’s return by maximising one’s leverage, is too hard to resist for many. Needless to say, such leveraged pursuits are often taken to extremes and end badly. Being encouraged to live beyond one’s means does not form a solid bedrock upon which to grow an economy, nor to maintain a healthy society.

Unfortunately, even for those who do not want to overextend themselves and chase the allure of leveraged returns, an inflationary monetary policy, including artificially low interest rates and the asset bubbles that they create, act to force most individuals to become dependent upon a bank in order to secure a place of their own to call home.

Widens wealth inequality and hits those who can least afford it the hardest

As a result of inflationary monetary policy resulting in increases to both the prices of the goods and services we consume, and asset prices, it contributes to widening wealth inequality on two separate counts.

Firstly, those who are richest own the most assets. As a result, they disproportionately benefit from the increase in asset prices that an inflationary monetary policy causes. At the same time, assets such as houses get further out of reach for ordinary, working-class individuals.

Secondly, the impact of inflationary monetary policy on raising the cost of necessary goods and services, further entrenches the lower classes into those rungs, as the rising cost of living means that they need to spend more of their income and savings (or get further into debt), just to purchase the bare necessities, as opposed to having money leftover to grow and invest. Given that lower socioeconomic classes spend more of their income on necessities than upper socioeconomic classes, they are disproportionately impacted by rising prices, exacerbating the gap between the rich and the poor.

This has flow on effects for social cohesion and a country’s political direction.

The misallocation of resources and painful economic corrections

As the saying goes, there is no such thing as a free lunch. Whilst inflationary monetary policy is temporarily stimulatory (and particularly so in cases of a large artificial increase in the money supply), once prices eventually rise, the increase in real incomes reverts, causing a contraction in real demand back towards its original, pre-artificial expansion of the money supply level. Instead of being stimulatory, an economic contraction then occurs to correct for all of the artificial stimulation and malinvestment that accumulated in the interim. The bigger the artificial increase, the bigger and more painful the economic correction is likely to be.

In terms of the current state of affairs, the US has seen two consecutive quarters of negative GDP. Sharp sell-offs have been seen in the Nasdaq and stock markets more broadly, as well as in cryptocurrency markets. The decrease in real incomes that high inflation has created, has resulted in surging credit card balances and slumping consumer confidence. While real durable goods demand has held up relatively well so far, a larger correction still appears likely as individual budgets continue to be stretched and their post-COVID excess savings are gradually withered away.

As opposed to being an inherent flaw with the capitalist economic model, the boom-bust cycle of economic growth is instead a flaw of the inflationist monetary policy that is generally undertaken by governments and central banks worldwide.

So many flaws, yet it’s all by design

Despite the significant flaws with our current inflationary monetary system, which has seen the US dollar lose 96.8% of its value since 1913, this is not by mistake, but by design. Indeed, the Fed, like most central banks around the world, has an official policy to create inflation year-in, year-out. Why would that be the case given all of its costs? Because it’s easier to sell to the masses, and benefits those making the decisions.  

As I outlined above, one must not forget that inflationary monetary policy does benefit some groups of people, and it particularly does so at the beginning of a new inflationary cycle, as the increase in the money supply is initially stimulatory. Pumping the printing press is thus an easy way for governments to shore up political support, particularly when the consequences of doing so can be passed on to the next government.

When the inevitable correction occurs, the politicians in charge can always scapegoat greedy corporations and individuals who took on too much risk and leverage, a pandemic, or whatever else can be reasoned at the time, and simply prime the printing press for another round of ‘stimulus’ to mask the current economic abyss—despite such measures usually being the real cause behind the current economic malaise.

The alternative to kicking the can down the road is dealing with the disease, with the addiction, here and now. Such a task would involve significant additional immediate pain. Whilst this would better serve a nation’s long-term economic prospects, the political leaders and policymakers will likely not remain in charge to take the credit. The far easier solution is to simply order another dose of pain relief.

Though just as the body builds a tolerance to the ongoing use of pain relief medication, and requires higher and higher dosages to have a similar effect, so too does an economy that has become addicted to an inflationary monetary policy. Notice how peak interest rates have generally trended lower and lower over the past 40 years? Notice how additional measures like quantitative easing were then adopted, and which have since been used in higher and higher amounts? Eventually no amount of pain relief will have an impact, and the can will have finally reached the end of the road. But as long as that will be somebody else’s problem to deal with, and as long as the majority of people demand more pain relief, the can will continue to be kicked.

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