Chapter 25: Inflation and Money
Many people have the erroneous belief that inflation is about the rising prices of goods in the marketplace, and this is largely because they experience it in the context of their own purchasing and do not consider the larger picture: inflation is caused by the debasement of the value of money.
It was easy enough to perceive in the days of commodity money: the consumer could perceive that the coins he handled were smaller or their color was different, and would accept that it was because they contained less silver, hence they were worth less, hence merchants increased the number of coins they demanded for merchandise. But in the present age of fiat currency, a "dollar" is an abstract concept that is not derived from anything that can be perceived. They are not aware when the federal reserve has increased the number of dollars on the market, and do not get that prices seem to be rising because their dollars are worth less . But that is the driver of inflation.
Naturally, that is not the only reason that money will change in value. A decrease in the supply of any good will increase the price of that good, a decrease in the supply of a common component (wheat) will increase the price of any good that contains it, and a decrease in the supply of labor will likewise increase the price of any good that relies on labor (which is everything, to varying degrees).
But shortages of goods and labor on a scale large enough to influence prices in the marketplace are very rare and often the consequence of natural disasters - whereas changes to the money supply are quite common and are the arbitrary decision of the central bank. Also, shortages and other factors that impact prices are temporary, whereas monetary policy decisions are permanent - they can keep prices ever rising because they are not caused or bounded by any natural occurrence in the physical world.
Why Have Central Bankers So Often Gotten It Wrong?
Given that the link between money supply and inflation is so clear, it seems plausible that central banks could very easily set monetary policy to stabilize their economies. But very often, they get things completely wrong.
The most obvious answer is that the central bankers do not necessarily act in the best interest of the public, and in some instances benefit both personally and politically from tinkering with the money supply. While they are ostensibly independent, they are subject to influence by politicians, who often want to stimulate the economy just before an election to bolster voter confidence, or who wish to get favorable interest rates on government debt.
Another problem is lag - the amount of time that passes between the occurrence of economic activity and the ability to collect, analyze, and transmit the data about those activities, as well as the amount of time to recognize and acknowledge that there is a problem that requires action, as well as the time that passes between the moment a decision is made and action is taken. Computers and networks can decrease some of these lags to a degree, but cannot eliminate all of them entirely.
Then, there is the problem of overreaction. The effects of a change in the economy are only predicted, not known until events have played out, and the central bank seeks to act to stabilize the economy, influencing the way the events play out. If there is a change that causes prices to fall, so the central bank will respond by increasing the money supply - and if it increases it too much, then there will be high inflation rather than stability. This is generally the reason the fed reacts slowly and moderately, making small changes over time - but the small changes can add up to a major mistake.
There is also a ripple effect as changes in monetary policy create reactions in the economy. Merchants are eager to raise their prices as soon as they learn the dollar is debased, but employers are not as eager to raise their workers' wages (hence they cannot afford as many goods, hence there is less demand for production, etc.). Investors are eager to shift their money to vehicles that provide higher returns, but borrowers are not eager to refinance their fixed-length debt to a higher interest rate and new borrowers may delay purchases if they believe the increase is temporary.
Another significant cause of inflation is budget deficits. To cover their expenditures, governments can either raise taxes, borrow at interest, or merely create new money. The latter seems like the better option - the least costly and the least likely to arouse consternation among the voting public - but the addition of new money devalues all money, and it becomes a vicious cycle that can lead to disaster, such as the hyperinflation that occurred in Germany during the Weimar Republic, in which prices doubled every two days.