Throughout history, high inflation has often led to social upheaval. Hyperinflation, when prices rise by 50 percent or more per month, helped bring the Nazis to power in Germany and the communists in Russia and China, and topple both civilian and military governments in Argentina. These, of course, are extreme forms of the disease. But, far more modest rates of inflation in the 1970s helped bring Margaret Thatcher to power in Britain in 1979 and drive Jimmy Carter from the White House.
Why is inflation so destabilizing?
Prices are the market’s air supply; they signal surpluses and shortages, and tell businesses and consumers when to produce more or consume less. Inflation contaminates the air supply. Suppose you are thinking of opening a new hotel and room rates are rising 10 percent. You may be thinking that they must be a sign of strong demand. But, what if the cost of land is going up 12 percent, linen by 11 percent, and chambermaid and maintenance wages by 13 percent? Your new hotel may actually lose money. Inflation makes it hard to interpret price signals.
Inflation also unsettles people because it arbitrarily punishes some people while it rewards others. When you buy a government bond that pays 4 percent, only to see inflation jump to 6 percent, your purchasing power gets clobbered. If you bought a home and were lucky enough to lock in a mortgage at 5 percent, and then see home prices soar 50 percent, you score a windfall.
Inflation is also a hidden tax. As wages rise to compensate for it, so does tax revenue, making it easier for the government to repay what it borrowed before inflation took off. In the process, however, it robs the currency in your wallet of purchasing power.
Another reason inflation is unsettling is that getting it back down is painful. The government may resort, as it usually does, to wage and price controls, or other heavy-handed interventions to reduce inflation. Usually, though, it takes a recession to cure inflation—and that hurts everyone.
Inflation’s dangers should not be overstated. It is hard to find evidence that steady inflation below 5 percent does much economic harm. The trouble is that as inflation rises, it gets less predictable. This year 6 percent, next year who knows?
Milton Friedman, the Nobel economist, said “Inflation is always and everywhere a monetary phenomenon.” He and many top economists blame inflation on too much money chasing too few goods. Intuitively, this makes sense. If you double the amount of money people spend on stuff, but leave the amount of stuff unchanged, prices will double.
In its most basic form, this notion is uncontroversial and economists of all stripes accept it. Historically, this has been one of the most consistent relationships in all of economics. In German prisoner-of-war camps, prisoners used cigarettes as currency, pricing bread, shirts, and chocolates in cigarettes. When Red Cross shipments arrived, suddenly everyone had more cigarettes to spend—and the prices of everything went up. As the cigarettes wore out or were smoked, prices started dropping again. Altering the supply of money has the same effect. When the government finances its spending with taxes or by borrowing, the money comes from taxpayers and savers. But if it finances its spending by printing money, or more precisely, by issuing bonds to the central bank, the money is created out of thin air. With all that extra money chasing the same goods and services, prices rise. In the extreme, this can produce hyperinflation, when prices rise 50 percent or more per month. In 2008 in Zimbabwe, prices were doubling roughly every day. Annual inflation equaled 89.7 sextillion percent (that’s 897 followed by 20 zeros). During such hyperinflations, people try to hold as little currency as possible. As soon as they’re paid, they spend the money before its value is wiped out. In many cases, people switch to foreign currency instead.
The bottom line:
1. Inflation is an increase in the quantity of money and credit. Its chief consequence is soaring prices. The term must not be misused to mean the rising prices themselves. Inflation is caused solely by printing more money. For this, the government’s monetary policies are entirely responsible.
2. The most frequent reason for printing more money is the existence of a budget deficit—the amount of government spending that exceeds government revenue. Budget deficits are caused by extravagant expenditures which the government is unwilling or unable to pay for by raising corresponding tax revenues. The excessive expenditures are mainly the result of government efforts to redistribute wealth and income—in short, to force the productive to support the unproductive. This erodes the working incentives of both the productive and the unproductive.
3. The causes of inflation are not, as so often said, “multiple and complex,” but simply the result of printing too much money. There is no such thing as “cost-push” inflation. Without an increase in the supply of money, and wage or other costs are forced up, and producers try to pass these costs along to the consumer by raising their selling prices, most of them will merely sell fewer goods and prices will drop. The result will be reduced output and loss of jobs. Higher costs can only be passed along in higher selling prices when consumers have more money to pay the higher prices.
4. Price controls cannot stop or slow down inflation. They always do harm. Price controls simply squeeze or wipe out profit margins, disrupt production, and lead to bottlenecks and shortages. All government price and wage control, or even “monitoring,” is merely an attempt by the politicians to shift the blame for inflation on to producers and sellers, and other scapegoats, instead of their own monetary policies.
5. Prolonged inflation never “stimulates” the economy. On the contrary, it unbalances, disrupts, and misdirects production and employment. Unemployment is mainly caused by excessive wage rates in some industries, brought about by either extortionate union demands or by minimum wage laws (which keep teenagers and the unskilled out of jobs).
The cure:
To avoid irreparable damage, the budget must be balanced at the earliest possible time. Balance must be brought about by slashing reckless spending, and not by increasing a tax burden that is already undermining incentives and production.