The Distortionary Effects of Monetary Inflation

One of the many demonstrably false myths of the official state religion — and by that I mean Keynesian economics — is the notion that we can have perpetual inflation at a “reasonable level” with no adverse affects. In this blog entry, I’ll demonstrate why this is indeed a myth.

Certain types of businesses do better during an inflationary environment, while others would (theoretically, at least) do better under a stable money supply, or even deflation. A clear example of a type of business that does well under inflation is anything connected to government — after all, with the Fed monetizing its budget deficits, the federal government gets new money first and dishes it out to government contractors. The more inflation, the more money there is for these economic rent seekers.

By contrast, a type of business that would do well under a stable money supply, or even better with deflation, would be “hard money” lenders. By this, I mean pawn shops, payday lenders, etc. After all, one of the advantages of being a debtor in an inflationary environment is that you get to pay off your debts with depreciating dollars. By the same token, if you’re a debtor in a deflationary environment, you have to pay off your debts with dollars that are worth more over time. This isn’t a very good deal for you, but it is for the lender.

Now hard-money lenders have a bad reputation in modern America — but they shouldn’t. After all, they’re only providing a service to customers who want loans and who can’t get them elsewhere. Do they charge high rates? Yes, but given that their customers are high credit risks, these rates are warranted. Perhaps the differential between what a poor credit risk is charged by a hard-money lender and what a good credit risk is charged by a Fed bank is larger than it should be, but that’s because Fed banks can create money for loans out of thin air, while hard-money lenders can only lend money that they actually have. If people with good credit did seek out hard-money loans, they’d pay much higher rates than they do with Fed banks.

In fact, the above is an example of what I’m trying to demonstrate. Inflation discourages hard-money lending, in general, though it keeps the business open to poor credit risks that the Fed banks refuse to serve. If we transitioned into a deflationary environment, in which banks did not create as much money to lend, then “higher quality” borrowers would seek out hard-money loans. The market for hard-money loans would thus expand, and with the expansion of the market, more firms would move into this business.

This is precisely why reversing the course on inflation is so politically difficult. As inflation becomes the norm, resources are shifted to businesses that are profitable in that environment. Reversing course would render these businesses unprofitable, and cause unemployment. And no politician likes unemployment — people out of work tend to vote for the other guy. This is why the Fed and the politicians who control it are always pushing for more and more inflation. They all hope that the can keep the corpse of the U.S. economy animated until they’re out of office. But I think they’ve finally pressed their luck too far this time.

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4 comments to The Distortionary Effects of Monetary Inflation

  • Dirk

    The Fed did run out of luck this time. They, once again, created a downdraft in economic activity by raising interest rates too high in 2006. Greenspan admitted as much when he said he was surprised how difficult it was to raise long term rates to slow down the growth in the housing market. To get rates to increase, he set the table for major depression, though the Fed is working overtime to counter this mistake.

    Money needs to be created as supply is created. Inflation will arise in some goods, but deflation will be offset in most. And the last major inflations in assets- tech stocks, houses- arose more from technological disruption and major tax change than money increase.

    If money is not created, deflation occurs. And the psychology of deflation is just not suitable to economic activity, let alone growth. While a constant money supply and a payday loan / pawn broker economy may work well in the hinterlands, it is wholly unsuitable for creating the solar/bio/urban/cyberspace economy of tomorrow.

    Big ideas, big investments, big risks, and big returns are required to continue mankinds growth and domination of our planet, and the economic- and monetary- policies of the 1800s (that led to the rise of Marx and Lenin) are wholly unsuitable for the coming century.

  • Hi Dirk,

    Economics has not changed. The same economic laws that bound entrepreneurs, kings and presidents 100 years ago still bind entrepreneurs, kings and presidents today. Ignoring the economic laws has the same disastrous consequences now as then, as we are experiencing with this bubble and crash. The damage caused by our present day mercantilists is the same as that caused by mercantilists in the days old.

    The railroad industry, the oil industry and the steel industry were all big ideas, big investments, big risks, and big returns. They all developed in a period of significant deflation so it is absurd to say that an inflationary environment it the only possible environment for development of big industries.

    There have been many periods throughout history where deflation or a lack of inflation was accompanied by great growth. The value of the dollar in 1913, before the establishment of the Fed, was approximately the same as it was at the founding of America. It cannot be disputed that there was tremendous growth and development during that time, a time with little, if any net inflation.

    Rapid, destabilizing deflation is very bad, just as rapid destabilizing inflation is very bad. Low, predictable rates of inflation or deflation are much less destabilizing. It is a logical error to believe that all deflation, at any rate, any time, from any cause is bad just because there have been some periods of significant destabilizing deflation, especially when those periods were preceded by significant destabilizing inflation. Using that same logic, every period of inflation, however slight must be bad because there have been times of destabilizing inflation.

    I would be interested to know what economic and monetary policies of the 1800’s, specifically, led to the rise of Marx and Lenin and are unsuitable for today’s economy.

  • Dirk

    Hi Dan,

    The railroad, steel, and oil industries were birthed and investment undertaken well before the Civil War. You think of them in the late 1800s because the deflationary policies of that period gave rise to the celebrity of Morgan, Carnegie, and Rockefeller. While I recognize the constructive role of the wealthy, it is also a matter of historical record that these policies also yielded crushing city slum conditions, farmer riots, call for silver money, and a rise in populism that gave us income taxes, the 8 hour workday, and consideration of alternative economic policies (like Marxism). Not to mention that 25% of railroads were in bankruptcy at the end of the century. And as we’re finding out now, resources spent on populist protectionism and government-led reorganization can be spent in better ways- like moving car factories to China, for example.

    We’ve seen a similar rise in populism in this current deflationary period. Much better were the broad growth of the 1920s and 1990s, both periods ended by Fed rate hikes and monetary constraint.

    Please understand I’m for less government spending, less government regulation, free trade, limited welfare, tort reform, and states rights. But deflation creates the wrong kinds of incentives in my opinion.

  • Hi Dirk,

    This is an excerpt from a book written in the late 1800’s:

    From the preface to “Recent Economic Changes” by David A Wells, published in 1899:

    “As an immediate consequence [of the development of technologies, industries and communications] the world has never seen anything comparable to the results of the recent systems of transportation by land and water; never experienced in so short a time such an expansion of all that pertains to what is called “business”; and has never before been able to accomplish so much in the way of production with a given amount of labor in a given time”

    It was exactly the rapid development of technology at that time, putting men out of work, that caused the unrest. Things did develop rapidly as this country and the world industrialized. People were forced, by progress, to change their ways of life, and it took a while to adjust. After it all, however, all people were better off with a lower cost of living.

    It is interesting to me that you use the 1920’s and 1990’s as examples, because they are the two of the most glaring examples in the last century of the absurdity and the dire consequences of irresponsible inflationary expansion. They are poster children of the Fed induced business cycle.

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