There is almost complete unanimity among economists and various commentators that inflation is about general increases in the prices of goods and services. From this it is established that anything that contributes to price increases sets in motion inflation. A fall in unemployment or a rise in economic activity is seen as a potential inflationary trigger. Some other triggers, such as rises in commodity prices or workers' wages, are also regarded as potential threats.
If inflation is just a general rise in prices as the popular thinking has it, then why is it regarded as bad news? What kind of damage does it do?
Mainstream economists maintain that inflation causes speculative buying, which generates waste. Inflation, it is maintained, also erodes the real incomes of pensioners and low-income earners and causes a misallocation of resources. Inflation, it is argued, also undermines real economic growth.
Why should a general rise in prices hurt some groups of people and not others? Or how does inflation lead to the misallocation of resources? Why should a general rise in prices weaken real economic growth? Also, if inflation is triggered by various factors such as unemployment or economic activity then surely it is just a symptom and therefore doesn't cause anything as such.
To ascertain what inflation is all about, we have to establish its definition. Now, to establish the definition of inflation we have to establish how this phenomenon emerged. We have to trace it back to its historical origin.
The Essence of Inflation
Inflation originated when a country's ruler, such as a king, would force his citizens to give him all their gold coins under the pretext that a new gold coin was going to replace the old one. In the process, the king would falsify the content of the gold coins by mixing it with some other metal and return diluted gold coins to the citizens. On this Rothbard wrote,
More characteristically, the mint melted and recoined all the coins of the realm, giving the subjects back the same number of "pounds" or "marks," but of a lighter weight. The leftover ounces of gold or silver were pocketed by the King and used to pay his expenses.
Because of the dilution of the gold coins, the ruler could now mint a greater number of coins and pocket for his own use the extra coins minted. What was now passing as a pure gold coin was in fact a diluted gold coin.
The increase in the number of coins brought about by the dilution of gold coins is what inflation is all about. As a result of the increase in the number of coins that masquerade as pure gold coins, prices in terms of coins now go up (more coins are being exchanged for a given amount of goods).
Note that what we have here is an inflation of coins, i.e., an expansion of coins. As a result of inflation, the ruler can engage in an exchange of nothing for something (he can engage in an act of diverting resources from citizens to himself). Also note that the increase in prices in terms of coins comes because of the coin inflation. Observe however that it is the increase in coins brought about by the dilution of gold coins that enables the diversion of resources here to the ruler and not an increase in prices as such.
Under the gold standard, the technique of abusing the medium of exchange became much more advanced through the issuance of paper money unbacked by gold. Inflation therefore means an increase in the number of receipts for gold because of receipts that are not backed by gold yet masquerade as the true representatives of money proper, gold.
The holder of unbacked receipts can now engage in an exchange of nothing for something. As a result of the increase in the number of receipts (inflation of receipts) we now also have a general increase in prices. Observe that the increase in prices develops here because of the increase in paper receipts that are not backed up by gold. Also, what we have is a situation where the issuers of the unbacked paper receipts divert real goods to themselves without making any contribution to the production of goods.
In the modern world, money proper is no longer gold but rather paper money; inflation in this case is an increase in the stock of paper money.
Observe that we don't say, as monetarists are saying, that the increase in the money supply causesinflation. What we are saying is that inflation is the increase in the money supply.
Note that increases in the money supply set in motion an exchange of nothing for something. They divert real funding away from wealth generators toward the holders of the newly created money. This is what sets in motion the misallocation of resources, not price rises as such.
Real incomes of wealth generators fall, not because of general rises in prices, but because of increases in the money supply. When money is expanded, i.e., created "out of thin air," the holders of the newly created money can divert goods to themselves without making any contribution to the production of goods.
As a result, wealth generators who have contributed to the production of goods discover that the purchasing power of their money has fallen, because there are now fewer goods left in the pool — they cannot fully exercise their claims over final goods, because these goods are not there.
Once wealth generators have fewer real resources at their disposal, this is obviously going to hurt the formation of real wealth. As a result, real economic growth is going to come under pressure.
General increases in prices, which follow increases in money supply, only point to an erosion of real wealth. Price increases by themselves however do not cause this erosion.
Likewise it is monetary inflation, and not increases in prices, that erodes the real incomes of pensioners and low-income earners. As a rule, they are the last receivers of money, often called the "fixed-income groups."
Particular sufferers will be those depending on fixed-money contracts — contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long-term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are "taxed."
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