The Effects of Inflation
Apr 28, 2009
Here are excerpts from commentaries
recently posted at www.speculative-investor.com
on 26th April 2009.
The Effects of Inflation
The effects of monetary inflation
are three-fold. First, it brings about an unwarranted transfer
of purchasing power (resources) to the creator of the new money
and/or the first user of the new money. Another name for this
unwarranted transfer is theft. Second, it has a NON-UNIFORM effect
on prices, leading to mal-investment and the wastage of resources.
The huge amount of savings and resources squandered in real-estate
investments over the past several years exemplifies the havoc
that can result from monetary inflation and why its effects cannot
simply be counteracted at some later time by "withdrawing
liquidity". Third, it EVENTUALLY results in a broad-based
increase in the prices of everyday goods and services.
Almost everyone focuses on the third of these effects, but the
greatest injustices and economic problems result from the first
two. The "Keynesians" and the "Monetarists",
for instance, are generally unaware of the first two effects.
In their fatally flawed views of the economic world, monetary
inflation either doesn't matter at all or doesn't matter unless/until
it causes the CPI to rise.
Based on traditional lead times, the substantial monetary inflation
that has occurred over the past seven months probably won't start
to become evident in the prices of everyday goods and services
until 2010. Furthermore and as mentioned in previous TSI commentaries,
the CPI will probably trend downward throughout 2009. This will
make the deflationists look right for the next few quarters even
though they will be wrong. They will be wrong because even while
prices decline, the inflation will be taking a heavy toll on
the economy by facilitating the transfer of resources to the
government and to failed businesses. The Keynesians argue that
the monetary inflation won't be a problem because the economy
will remain weak due to "insufficient aggregate demand",
but they fail to realise that "insufficient aggregate demand"
doesn't cause anything [
* ] and that monetary inflation is one
of the main reasons why the economy is destined to remain weak.
We are far more bearish on economic growth and employment than
the mainstream economists who are predicting deflation, and yet
we expect an upward trend in the general price level to begin
within 12 months. Our expectation is not outlandish because economic
weakness will not prevent a currency from losing its purchasing
power in response to substantial growth in its supply. In fact,
it's the other way round. The less stuff that gets produced by
the economy the greater will be the eventual decline in the currency's
purchasing power stemming from monetary inflation. Or, to put
it another way, real economic growth puts downward, not upward,
pressure on the general price level, so during periods when the
economy is weak there will be greater potential for increasing
currency supply to bring about higher prices (after the usual
'confusing' lag, of course). During 1933-1940, for example, the
unemployment rate was stuck in the 14%-20% range and yet prices
trended upward in response to a moderate increase in the money
supply (the US Government/Fed couldn't increase the money supply
at will during this period due to the remaining vestiges of the
Gold Standard). Prices also trended upward in parallel with high
unemployment during the 1970s, again due to growth in the money
The effects of monetary inflation will work their way through
the economy over the next few years, but the theft is happening
right now. We suggest that the deflationists stop going on about
how the amount of money created 'out of thin air' is small compared
to the declines in asset and debt prices (and thus encouraging
the Fed to counterfeit money at an even faster pace), and start
emphasising the problems inherent in the inflation.
Either through luck or skillful
manipulation, the Fed has managed to bring about a sizeable increase
in the US money supply over the past seven months while preventing
the money supply growth rate from spiraling out of control. At
the beginning of this year there appeared to be a significant
risk that the monetary situation would spiral out of control,
but things have since settled down. For example, US M2 money
supply is down by around $100B over the past four weeks and is
almost flat over the past 11 weeks, causing the year-over-year
M2 growth rate to drop back from 10% to 8% (we haven't re-calculated
TMS, but the TMS and M2 growth rates have tracked each other
closely over the past several months).
The year-over-year growth rate in the money supply is likely
to resume its upward trend over the coming months, though, because
the Fed is likely to ramp-up the rate at which it monetises bonds.
In fact, such a ramp-up appears to be underway in that the Fed
monetised (purchased with newly created money) $75B of mortgage-backed
securities and $14B of Treasury Bonds during the week ended 22nd
demand will never be "insufficient" until everyone
has everything they want, which means it will never be insufficient.
What Keynesian economists refer to as "insufficient aggregate
demand" is the increased tendency to save, and the corresponding
reduced tendency to spend, after savings have been obliterated
on a grand scale due to the mal-investments prompted by the preceding
inflation-fueled boom. A fall in prices is one of the ways the
economy heals itself in the aftermath of an inflation-fueled
boom. Generating more inflation prevents the healing process
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