Tuesday, August 18, 2009

How Inflation Breeds Recession

This article is based on a paper delivered January 6, 1975, at a monetary conference in Miami.

Both general economic and purely monetary theory are supposed to have made immense advances since the middle of the eighteenth century, yet the confusion and chaos in economic and monetary theory have never been greater than they are today. One would think, listening to television and reading the newspapers and mag­azines, that inflation — in the pop­ular sense of soaring prices —were some infinitely complicated, mysterious and incurable afflic­tion that had suddenly struck us from the blue, instead of simply what it is — the inevitable conse­quence of the actions of government in overspending and then printing paper money.

And as the cause is obvious and simple, so is the fundamental cure.

The direct cause of soaring prices is printing too much paper mon­ey; the direct cure is to stop printing it. The indirect cause of inflation is government over­spending and unbalancing the bud­get; the indirect cure is to stop overspending and to balance the budget.

But if the cause and cure of in­flation are so fundamentally sim­ple, why is there so much befud­dlement? One reason, of course, is that the problem is not merely economic, but political. The prob­lem is not merely, for example, to get the politicians to recognize the true cause and cure of inflation. It is also to get them to acknowl­edge that cause and adopt that cure. In brief, one reason so many politicians do not understand the problem is not merely that they are too stupid to understand it, but that they do not want to understand it.

They realize that inflation is a political racket. They find that the way to get into office is to advocate inflation, and the way to stay in is to practice it. They find that the way to be popular is to appropriate handouts to pressure groups who represent mass votes, and not to raise taxes except those that seem to fall mainly on some unloved or envied minority group — oil companies, corporations gen­erally, the reputedly "rich" or "superrich."

The ultimate result of such poli­cies is to bring about exactly what we have today — inflation plus re­cession.

But we are brought back to the fact that politicians could not ex­ploit the befuddlement of the pub­lic about inflation if that befud­dlement did not already exist. So though we must not overlook the political side of the problem, we must recognize that our main task is still one of educating the public.

This is a much bigger problem than it is commonly thought to be. Even when we have explained to people that inflation is caused by excessive issues of paper mon­ey, and by budget deficits that lead to excessive issues of paper money, we have done only a small part of our task. We have ex­plained what causes inflation, but we have not explained why infla­tion is so pernicious. The truth is that the greater part of the pub-lie still thinks that inflation is on the whole beneficial. They know that it raises the prices of com­modities, but the chief thing they consider bad about this is that it may not raise their wage-rates or salaries to the same extent. Near­ly everybody thinks that inflation is necessarily stimulating to busi­ness, because they think it must raise profit margins and so lead to greater production and employ­ment.

This is indeed usually true in the first stages of inflation. But what is still recognized only by a tiny minority is that in the later stages of inflation this ceases to be true. In its later stages inflation tends to bring about a disorgani­zation and demoralization of busi­ness.

It tends to do this in several ways. First, when an inflation has long gone on at a certain rate, the public expects it to continue at that rate. More and more people’s actions and demands are adjusted to that expectation. This affects sellers, buyers, lenders, borrowers, workers, employers. Sellers of raw materials ask more from fabri­cators, and fabricators are willing to pay more. Lenders ask more from borrowers. They put a "price premium" on top of their normal interest rate to offset the ex­pected decline in purchasing pow­er of the dollars they lend. Workers insist on higher wages to compensate them not only for present higher prices but against their expectation of still higher prices in the future.

http://www.thefreemanonline.org/featured/how-inflation-breeds-recession/

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