Opinion from a Libertarian ViewPoint

Understanding the inflation problem

Posted by M. C. on January 21, 2022

More difficult, perhaps, will be the discipline sound money imposes on government spending. From the state’s point of view, the purpose of inflation is to permit it to spend more than it raises in taxes. For money in the form of gold coin to back a fully exchangeable currency requires abandoning inflation as a source of finance.

By Alasdair Macleod

In recent weeks inflation has become a major economic concern. Nearly all the commentary emanating from monetary policy makers, economists, and the media is misguided, believing inflation is rising prices and must be addressed accordingly.

They are only the symptoms of inflation. The true cause is the expansion of currency and bank credit, which, reflected in the US dollar’s M2 money supply has increased substantially since March 2020, and now stands at nearly three times the level when Lehman failed.

After defining the differences between money, currency, and credit which together make up the media of exchange, this article explains how changes in the quantities of currency and credit translate into prices.

The solution to the inflation problem is not price controls, which are always counterproductive, but to return to a regime of sound money. This article shows what must be done to achieve this outcome and concludes that it is impossible to do so without a sufficiently serious financial and economic crisis to discredit government intervention in markets and to then allow governments to stabilise their currencies and reduce their spending to a bare minimum.

Defining inflation, money, currency, and credit[i]

A resolution of the inflation problem requires an understanding of inflation itself. It is an increase in the quantity of the media of exchange, whether it be money, currency, credit, or a combination of any or all of them. It is not a rise in the general price level. That is the consequence of inflation when the media of exchange loses purchasing power.

To avoid misunderstanding, it is important in any discussion about money to provide an accurate definition of what is money and what is not money. Let us clarify this at the outset:

That which is commonly referred to as money is more correctly any form of circulating media used for the payment of goods and services in an economy based on the division of labour. The term “circulating media” or “media of exchange” more accurately represents the common concept of money as the term is used today.

The amount of circulating media is never fixed. Indeed, the quantity of metallic money — gold, silver, and copper, but particularly gold, which we can simply define as pure money with no counterparty risk, has increased over the millennia since weights of these metals first evolved to replace barter. The population of active users of metallic money has also increased. Throughout history, the pace of increases of above ground gold stocks and the human population have been similar. The quantity of gold has therefore broadly kept pace with the population increase.

Over the long term, therefore, money proper has ensured a stable purchasing power despite the increase in above-ground stocks. An important advantage of gold as money is that its use is dominated by the twin functions of ornamentation and as the medium of exchange — unlike silver and copper it is never consumed. Gold’s utility is set by its users, who collectively decide how much circulates as money and how much is used for ornamentation. Its use switches between these two functions as its possessors collectively impose their needs, and gold’s purchasing power is determined by the quantity circulating as money. As well as the flows between its use as money and ornamentation, the quantity of money can also be affected by variations in mine supply from its general correlation with global population growth.

Gold’s purchasing power is stable due to these self-correcting factors. Currency is a different matter, always bearing in mind the counterparty risk of the issuer and its propensity to inflate its quantity. Today, these are central banks. A central bank’s balance sheet always shows currency in circulation as a liability of the bank, along with deposits owed by it to its depositors, normally confined to licenced commercial banks. The quantity of currency in circulation is set not by its users, but by the central bank managing its balance sheet.

In accordance with their monetary policies, Central banks can and do vary the amount of currency and the deposits recorded on their balance sheets, the latter more normally termed the reserves of commercial banks. Setting the level of these reserves in addition to a commercial bank’s shareholder capital used to be the means of regulating the quantity of credit that a commercial bank could issue. But today, central banks actively buy financial assets, payment being credited to the reserve accounts of the commercial banks. It is now the principal source of central bank inflation, and the regulation of a commercial bank’s lending capacity is now controlled more by other forms of regulation.

A commercial bank is a dealer in credit. It lends money to borrowers at a higher rate than it pays to its depositors. By lending money, it creates an asset on its balance sheet, and at the same time a counterbalancing liability is credited to the borrower, representing the amount of credit that the borrower has available to draw upon. The borrower’s bank statement will not usually reflect the counter-deposit, but double-entry bookkeeping demands that it exists. By a few strokes of a bookkeeper’s pen, credit which is indistinguishable from currency is created out of thin air and put into circulation.

We therefore have three types of circulating media: money, currency, and credit. A central bank sets the quantity of currency, and the commercial banks the quantity of bank credit and therefore deposit money, which is bank credit’s counterpart. The only circulating media whose use-value is set by its users is money. For the modern state which demands control over what circulates as the circulating media, money is actively discouraged in favour of its own substitutes, currency and bank credit issued by its licenced commercial banks, which it controls. Even under a gold coin standard, very few transactions involved money, being almost entirely settled by currency and credit.

The consequences of inflation

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