Oil and commodity prices are soaring. Inflation has reached a seven year high. As the thief who cries “Catch the thief!” the politicians are blaming it on everyone else, except their own policies. Economists are placing the blame on a food shortage. Everywhere, the effect is being confused with the cause.
Inflation is, and always is, an increase in the supply of paper money or bank credit. When there is more supply of money, people value the money less. This leads to a general increase in prices. An increase in supply of bank credit too would lead to the same.
When money is injected in this mode into the economy, it first reaches the people whom the governments pay. Let’s assume that these are the defense contractors or the farmers whom the government pays subsidies. Then, the money ripples out and spreads through out the entire economy. When it ripples out, the demand for the goods increase and hence, the prices rise.
Usually, when there is a budget deficit, the Reserve Bank of India purchases government securities, against which it creates checking deposits. This is how paper money is created. It should be kept in mind that budget deficits in itself are not inflationary. Budget deficits are not inflationary if they are financed by bonds sold to the public paid out of real savings.It certainly doesn’t mean that budget deficits financed in this manner doesn’t have harmful consequences. It hampers production and misallocates resources.Inflation can occur even if there is a budget surplus if there is an increase in money supply notwithstanding.
Governments usually inflate in order to buy armaments during a war period. They inflate in order to buy the votes of the public without their knowing it. They inflate in order to provide subsidies to certain political pressure groups. They inflate under the false belief that it would cure unemployment. Inflation is in fact a tax we pay irrespective of our income levels. It leads to reckless income redistribution in a wanton fashion. It discourages saving and encourages speculation. It wipes out morality.
Inflation would always end in a crisis and a depression and worse, people would then blame the depression on the inherent defects of capitalism. It is worth remembering that people blamed the great depression on the inherent defects of capitalism and that led to sweeping reforms that took people into a welfare state oriented society.
The only cure for inflation is to stop the expansion of money and credit. It is as simple as that. If we had instituted a gold standard, which means, if paper money was redeemable in gold on demand, it would have put an automatic rein on the extent over which they can inflate. It would have stopped inflation altogether. And this exactly is why they abandoned the gold standard. And this is why we badly need it.
Inflation derives from the doctrine that what we need is not a gold standard, but monetary management. Monetary management, but is a euphemism for government manipulation of money and credit, which is the root of inflation. It should be remembered that a century back, every economist of repute believed in a gold standard. It required decades of government propaganda and obfuscation to change the tide.
The gold standard was abolished only because it wouldn’t let them inflate when it seems to them that they should. On a gold standard, each money would be defined in terms of gold and all international currencies would be anchored to each other. It would put a stop to fluctuating exchange rates and would lead to a fixed exchange rate.
There are economists who believe that monetary management is needed and we should increase the money supply in relation to the increase in goods and services. They believe, otherwise, that it would lead to deflation and depression. The absurdity of the doctrine becomes clear when we think that how we would compare the increase in goods and services in relation to the increase in money supply. It is true that if let alone, the prices would fall every year, but that wouldn’t affect the profit margins. The total demand would be sufficient to buy the products at lower prices and there wouldn’t be a depression or unemployment.
It is also believed by some pseudo-economists that inflation would cure unemployment. But, the real effect of inflation is to hamper production and reduce employment. The only situation in which inflation would boost employment is when a deflation has occurred and the labor unions are not to use their power to raise wages. But, to say that inflation is a cure for unemployment is tantamount to saying more drugs is a cure for withdrawal symptoms.
Critiques of Some Popular Explanations of Inflation
Could less supply be the cause?
Whatever be the popular perception, in reality, the tendency has been that the supply increases each and every year. If so, the real effect has to be that the prices should fall every year. In fact, the impact of rising supply has been so overwhelming that in United States, prices have fallen every year from the mid half of the eighteenth century to 1940, with the sole exception of Napoleonic wars, Civil war and World War I. It was only during the wars when Governments ran the printing press at full blast that the prices had to rise. There was of course, paper money in those days, but the exceeding supply offset those increases in paper money.
Even in cases when supply has come down, as in Chile in 1970’s and Uruguay in 1960’s the role of falling supply has been minor in the price rise. The supply had only fallen to a certain extent, but the prices rose thousands of times. Moreover, if we take falling supply as a cause for general price rise, it would imply that the supply has been falling through out every year, as prices have been rising at an amazing pace. That would imply the general disappearance of human civilization, which obviously isn’t happening. Such an analysis would make it obvious that the falling supply is not the reason and something else is wrong.Moreover,if there was free trade,goods would move in to the country where there is falling supply.That would have solved the problem.It should be kept in mind that it is the Governments which are the biggest enemy of free trade.
It should also be taken in to account that supply would fall if there is an extreme rise in aggregate demand. It means that supply would fall with an increase in paper money, which obviously is one of the causes for a fall in supply in many of the cases. Every time an inflation occurs, people scream that there is a fall in supply going on. It is so ridiculous and it would be worth pointing out that in Germany of 1923,after priced had soared hundreds of billions of times, high officials and even the people were blaming it on the shortage of goods and at the same time foreigners were buying German products at a price lower than what would they have had paid in their home country with their own currency or gold. Even in conditions of war, we do not see a general rise in prices due to a decrease in supply.
Some Indian Economists with inadequate knowledge of the subject, like Swaminathan Anklesaria Aiyar was pointing out that inflation is not always a monetary phenomenon and in India, inflation has always occurred after major droughts. But, it is well known that the prices have been rising continuously in India for the past several decades. His argument would imply that there were droughts continuously and material civilization is slowly disappearing, which, obviously isn’t true. It should be apparent now that it is utterly illogical to blame inflation on droughts and famines. It should also be kept in mind that famines are created by Governments.
A fall in supply also can’t explain the debtor/creditor effects of inflation. During an inflation, the debtors gain at the expense of creditors. A fall in supply of goods can’t explain this. Only an exorbitant rise in the amount of paper money can be an adequate explanation for this. Moreover, the argument that a fall in supply is the cause of inflation would imply that a rise in supply would lead to deflation and depression. It is obvious that a rise in supply would lead only to prosperity and this alone would be enough for us to reject a fall in supply as the cause of inflation.
The believers of the cost-push doctrine think that an increase in demand would not raise prices in a situation where unemployment exists. They think that it would lead to more employment and hence, more production. They blame the price rise on some arbitrary power such as the rise of some costs. The prices, in their opinion rise when certain costs rise and they would be satisfied to leave the matters at that. Let’s perform a mental experiment. Let’s keep the demand constant imagine what should happen in order to the prices to rise. It should be obvious that the supply should fall is the demand is kept constant in order for the prices to rise. We have already rejected a fall in supply as the cause of inflation. Hence, we should reject the cost-push doctrine too.
People unsympathetic to labor unions hold that it is labor union coercion and wage demands that lead to a rise in wages and hence inflation. It is true that labor union coercion has serious repercussions. But, if it was only labor union coercion that was in action, it would only lead to more unemployment. When the funds to pay wages are fixed, the demand for more wages would lead to the firing of some employees. Yet, if the question is whether labor union coercion would lead to inflation, the answer would be that economically “No” and politically “Yes”. When labor unions demand for more wages, the government injects more paper money into the system to prevent unemployment. This leads to inflation. Here again, it is proven that the quantity theory of money is the only explanation for inflation.
The advocates of Profit-Push doctrine believe that the businessmen rise the prices in order to raise profits and this leads to a general rise in prices and hence, inflation. This stems from a gross misunderstanding of the market economy. It is obvious that they will have to cut down the sales when prices are raised recklessly. It is a characteristic of market economy that a striving for profits leads to an increase in supply and hence lower prices. Unfortunately, in many cases, the lowering of prices is obscured by inflation, the injection of paper money. What gives credence to this Profit-Push doctrine is that the nominal profits rise during inflation. Inflation shows the profits of business firms as a lot higher than it is. But, the fact is that real profits fall during inflation.
Crisis-Push doctrine holds that a certain crisis as the Arabian Oil embargo of 1973 is the cause for inflation. A crisis can of course, explain a price rise of a particular item, such as oil or wheat, but it can’t explain a general rise in prices. When the price of a particular item rises, the price of other items does not rise, they in fact fall. People will have to divert their resources to products which’s prices rise and hence they would have to cut short their purchase of other items and hence their prices fall. When the price of oil increases, for instance, it reduces the sale of automobiles and hence its prices are likely to come down. A rise in price of oil too is likely to make substances such as copper, rubber, iron etcetera useless. The wage rates of the workers who work in processes of production that depend on oil also comes down. Hence, we will have to reject the Crisis-Push Doctrine too.
Wage-Price-Spiral doctrine holds that the wages rise because prices rise and prices rise because wages rise and both leads to a spiral. The arbitrary rise in prices and wages were already rejected as the cause of inflation.
Velocity of Circulation Doctrine
Velocity of Circulation doctrine holds that an increase in velocity of circulation of money causes inflation. It is a classic example of the effect being seen as the cause. The increase in velocity of circulation is merely a cause and inflation is the effect. It is a rise in paper money that leads to high velocity of circulation of money and not the other way round. When there is a rise in paper money, people tend to buy anything and everything as they find it dangerous to hold money in their hands. This leads to a rise in prices. Here, it should be kept in mind that this phenomenon is only an effect of the injection of paper money, not as some statists would want us to believe.
Inflation Psychology doctrine
The advocates of inflation psychology doctrine are of the view that it is an inflation psychology that leads to a general rise in prices. When the workers anticipate that there would be a rise in inflation, they would demand higher wages. When businessmen anticipate inflation, they would raise the prices. But, this is not an adequate explanation. In the first place, how did this inflation psychology come in being? It is out of the hard won experience of people. If we had instituted a gold standard, there wouldn’t be any inflation and hence there would be no inflation psychology. Such explanations should be rejected beforehand.
Credit Card doctrine
The supporters of the credit card doctrine thinks that people holding credit cards needn’t hold as much money as they have to and this leads to more spending and hence an increase in prices. This, but, is an entirely fallacious notion. It would only lead to an increase in prices only because the banks can extent the line of credit. They can extend the line of credit only because they can create checking deposits which they lend out. Thus, we again come to the conclusion that only an expansion in money supply would lead to inflation.
Advocates of this doctrine believe that the granting of consumer installment credit leads to more spending and hence inflation. This is true only to the extend that credit is granted out of newly created money. It would not be true if the credit was granted out of saved funds. If the credit was granted out of the saved funds, the savers first have to restrict their consumption before the consumer borrowers can expand their consumption. There is only a transfer of spending power from one group to other.
Consumer Greed doctrine
American President George Bush has accused that it is the greed of Indian consumers that leads to inflation. The supporters of this doctrine hold that it is the greed of consumers that lead to a rise in prices. But, it doesn’t give us answer to the question that where does they get the funds to spend according to their new greed. It may give us an explanation for the rise in price of a particular item, but not the rise in prices in general. They would have to restrict their consumption of other items if they purchase a particular item in excess. Moreover, greed would lead not to more spending, but harder work and greater supply.