Freeman

ARTICLE

The Mystery of Inflation

JULY 01, 1978 by HARRY C. KNICKERBOCKER JR.

Harry Knickerbocker is a veteran writer and public relations counselor who presently employs his skills as a consultant on effective tree enterprise advo­cacy.

Recently, as I read the Sunday edi­tion of a major metropolitan news­paper, I counted nine columnists whose subject of the day included explanations of inflation. The only clear-cut fact that emerged from this scatter shot of expert opinion was a common failure to deal with the cause of inflation. Rather, they were talking about price increases.

This confuses cause and effect and ignores the fact that some responses to inflation do not include price increases—in fact, in some in­stances, prices actually decline. Re­ductions in production costs arising out of new technologies can alleviate—and conceal—the fact that inflation is under way. Other concealments can include producers’ reduction in the quality and/or size of their goods or services, reduction of consumer demand with resultant suppression of price increases, and a myriad of other variables and un­knowns.

A tool for measuring inflation’s effects may never be available and, despite a certain usefulness that such measurements might have, to seek such a tool implies acceptance of inflation as a natural phenom­enon—something to be measured, harnessed and put to proper use. With recognition that this concep­tion of inflation is fallacious can come the realization that the objec­tive is not to use it, but to eliminate it; not to quantify it, but to be able to detect its presence. Indispensable to the achievement of these objectives is a clear, accurate grasp of the real nature of inflation, its origins and its cause.

Inflation consists of enlarging a nation’s money supply by the addi­tion of something other than real money, i.e., something other than the money metals, gold and silver. It became possible to make such addi­tions in substantial quantities with the introduction, acceptance and use of paper money.

Money Substitutes

Paper "money"—and, of substan­tially less significance, token coins—is the only money that most of us have ever known. It came into use as a substitute for real money that had been placed in storage for safekeeping. Originally, bank notes were warehouse receipts for stored gold, and checks were written orders from owners of the gold instructing warehousemen to pay specific amounts of gold to the persons named in the orders.

Confident that one another’s re­ceipts were readily redeemable for gold, traders quickly found that transacting business with money substitutes was more convenient than using gold—which would have to be withdrawn from storage by the buyer and then re-deposited by the seller. From the outset, most depos­itors left their gold in storage and paid for purchases with either re­ceipts or checks.

Confidence and convenience not-withstanding, it was only in the role of substitute that paper currency could gain acceptance among trad­ers to perform the functions of real money. For these paper substitutes had not progressed through the bar­ter process which gives a commodity the capacity to function as money.

Barter, the exchange system characteristic of primitive societies, imposes severe limitations on its participants. Each has to try to match his wants with things wanted by other producers. As in the tradi­tional example, the community’s wheat grower might want candles at a time when the candle maker wanted cloth, the weaver wanted shoes, the cobbler wanted a hat, the hatter wanted beaver skins, the trapper wanted pork, and so on. For any two traders simultaneously to want exactly what each other of­fered and to be satisfied with the amounts each was to give and get in exchange would be very unlikely. To get the candles he needed, the wheat farmer might have to make a series of less than satisfactory trades to obtain cloth to offer the candle-maker. Meanwhile, the market’s other traders would be experiencing the same difficulties.

As such a process—crude, time consuming and inefficient—labor­iously plods along, one commodity is likely to emerge as easier to trade than other goods. As it does, it gains an additional value. It is demanded not only for its commodity value but for its usefulness as a medium of exchange. Gradually, all producers seek to trade their wares for this commodity because, with it, they can trade directly for any item they want.

As this commodity becomes ex­changeable for any good offered in the market, exchange rates are estab­lished between it and each of the other goods. These rates are, of course, prices, and the ability to ex­press prices is the identifying prop­erty of money.

This is the only way that money can originate. Any attempt to origi­nate money by arbitrarily designat­ing officially approved certificates (or any other items) as the medium of exchange would fail. Being of­fered for trade as a commodity is the inescapable starting point from which an item must begin enroute to becoming the easiest-to-trade com­modity.

Although real money must origi­nate as a commodity, the ability to function as money can be trans­ferred to money substitutes. Trans­fer of the money function from stored gold to subsidiary coins, checks and deposit receipts repre­sented a refinement, a further streamlining of the exchange pro­cess. Unfortunately, inherent in the refinement was an opportunity for misuse with disastrous conse­quences.

Fractional Reserves

With the use of substitutes enjoy­ing such strong acceptance among traders, the amount of gold that con­tinued to circulate—to be with­drawn and re-deposited—was never more than a fraction of the total in storage. Noticing that the value of receipts presented for redemption consistently amounted to only a fraction of the deposited gold, some warehousemen conceived of an in­novative scheme for creating a new business. They wrote receipts for several times as much gold as actu­ally was stored in their vaults. Then with the "extra" receipts, the im­aginative warehousemen went into the lending business.

This created claims for several times the amount of gold deposited, but warehousemen expected no problems because the extra receipts were simply on loan and would be returned when borrowers’ notes came due. The lenders failed to realize that the extra receipts in the market would set in motion a pro­cess that would make a money crisis inevitable.

The net effect of issuing receipts for amounts of gold several times the actual deposits was tantamount to a sudden, miraculous multiplica­tion of the amount of gold without cost or effort. At first, this would create an illusion of instant, unlim­ited prosperity. Business would boom, but the illusion would quickly fade because the purchasing power of gold—its value in relation to other goods and services—would plummet. And, so it was with the flood of "extra" receipts.

Members of the community en­dured the frustration of rising prices until someone remembered one price that couldn’t rise. Each receipt stated a fixed amount of gold pay­able to the bearer on demand.

The ensuing rush to withdraw gold (a frequent necessity which eventually became known as a "run" on the bank) confronted the ware­housemen-bankers with an insolu­ble dilemma: they could not demand payment of borrowers’ notes until the future dates specified in the notes. On the other hand, the bank­ers’ warehouse receipts were de­mand "notes." Receipt holders could demand immediate payment of their gold. Only a fraction of the receipts could be redeemed. The fractional reserve banks had no hope of meet­ing their obligations.

Given the clearly fraudulent na­ture of lending claims to nonexistent property, it is reasonable to expect that the practice was outlawed. His­torically, however, when depositors have tried to protect themselves from the fractional reserve method of theft—when depositors have presented their receipts and de­manded their gold—governments have usually granted the banks immunity from their obligations and from retribution. Eventually, governments and their central banks (Federal Reserve System in the U.S.) assumed control of the is­suance of unbacked notes.

Persistently refusing to acknowl­edge the fallacious nature of frac­tional reserve banking’s basic prem­ise, governments and their experts have derived a succession of modifi­cations each of which has been ex­pected to make the system "work." Among the most basic of these was the forcible demonetization of gold and the establishment of govern­ment sanctioned paper money as the exclusive medium of exchange.

Outlawing Gold

Gold’s function as money was halted in the U.S. in 1933 when Americans were prohibited from owning the money metal and from requiring payment of obliga­tions in gold. Federal Reserve Notes were designated as "legal tender." By denying the freedom to choose gold in preference to inflatable frac­tional reserve money, government clearly stood ready to prevent note, holders from protecting themselves from inflation’s theft.

From the fractional reserve bank­ing point of view, the prohibitions and restrictions have been very suc­cessful. By 1975, when Americans’ right to own gold had been restored, and by 1977 when it again became legal to specify payment of obligations in gold, decades of enforced disuse had long since divested gold of its ability to express prices.

Passage of the Gold Clause Bill (P.L. 95-147) in late October, 1977 permits lenders to specify either "legal tender" or gold for repayment of their loans. This gives gold some chance to regain its money function, but in circumstances much different than the barter conditions in which it initially achieved status as the most easily traded commodity.

For gold, remonetization means competing with what was once its substitute but is now the estab­lished, accepted medium of ex­change. As shaky, unreliable, and disaster-prone as fractional reserve money is, it is still open to question whether or not Americans will be willing to take the trouble to reinstate gold. The decision is likely to be influenced by our perception of the harm that inflation is doing. In this regard, it may be useful to ob­serve certain important distinctions.

Production of gold money requires an investment, an input of actual, real, existent resources. The resul­tant money is equally real and con­stitutes value added to existing val­ues. To be sure, as with any com­modity, overproduction of the money metal could diminish its value vis-a-vis other goods and services; but the consequent losses to the pro­ducer would quickly terminate or curtail production. Owners of gold would have no fear of seeing the value—the purchasing power—of their medium of exchange swept away in a limitless flood of gold.

In sharp contrast, production of fractional reserve money requires little more than making a book­keeping entry crediting a borrower with an agreed upon sum and issu­ing a deposit receipt in this amount. Where in one instant there had been nothing—literally—in the next in­stant there is "money." Whereas production of gold money added value to the economy, money created out of thin air acquires its value by taking it from existing val­ues without giving anything in ex­change.

Today, all production of additional money is inflation. The "Fed" (Fed­eral Reserve) has several ways of increasing the money stock, each of which creates money out of thin air. When the powers of government de­termine that more money should be spent than can be collected in taxes (more than taxpayers will tolerate), government simply borrows non­existent money from the Fed.

As it is spent, the new money flows into deposits in commercial banks. There it becomes the frac­tional reserve for a much larger amount of money created out of nothingness by virtually the same loan scheme devised by the original warehousemen-bankers.

That, in brief, is inflation.

ASSOCIATED ISSUE

July 1978

comments powered by Disqus

EMAIL UPDATES

* indicates required

CURRENT ISSUE

November 2014

It's been 40 years since F. A. Hayek received his Nobel Prize. His insights, particularly on the distribution of knowledge and the impossibility of economic planning, remain hugely important today. In this issue, we look back on the influence of his work. Max Borders and Craig Biddle debate whether liberty must be defended from one absolute foundation, further reflections on Scottish secession, and how technology is already changing our world for the better--including how robots, despite the unease they cause, will only accelerate this process.
Download Free PDF

PAST ISSUES

SUBSCRIBE

RENEW YOUR SUBSCRIPTION