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Thursday, February 9, 2023

Inflation Not Only Hurts, It Diverts

Inflation is a government externality that has made my favorite cookies twice as expensive.

Image Credit: regularguy.eth on Unsplash

Inflation sucks. When I was a kid, a pack of Oreos would cost $2.99: cheap and reasonable. Now, I would need to shell out about $5 for the same product—and I’m only 23!

Even beyond shattering the hopes and dreams of young children craving milk’s favorite cookie, the situation is worse than most people realize, because there is a little-known ramification.

Inflation not only hurts, it diverts. It economically harms the many by redistributing their wealth to a few.

The True Meaning of Inflation

To understand how, we must first get clear on what inflation really is.

Henry Hazlitt once said, “Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit.” In fact, inflation is the increase in the supply of money and credit.

At least that was the original definition. But inflation has been redefined as an increase in the general price levels of goods and services. However, using inflation to mean a rise in prices, Hazlitt argued, “is to deflect attention away from the real cause of inflation and the real cure for it.”

Intuitively, this makes sense. For instance, if there is a natural disaster that disrupts the production of Oreos (what economists call a “supply shock”), they become more expensive because there are fewer cookies available. Alternatively, if a new recipe that uses Oreos becomes wildly popular (a “demand shock”), the rise in demand for Oreos also makes them more expensive. But money was not devalued in either of these scenarios. Oreos just became more valuable. Thus supply or demand shocks are not changes in the prices of all goods, but are specific to the goods affected, and the rise in the price of those particular goods reflects the newfound scarcity or demand. So it doesn’t make sense to call that “inflation.”

True inflation is the devaluation of a currency that makes each dollar worth less. As Hazlitt explained:

“When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase — or does not increase as much as the supply of money — then the prices of goods will go up. Each individual dollar becomes less valuable because there are more dollars.”

Progressives like Sen. Elizabeth Warren and Robert Reich blame inflation, not on monetary expansion, but on corporate greed.

But this makes zero sense. As FEE’s Dan Sanchez argued, “blaming rising prices on profit-seeking is like blaming a plane crash on gravity.”

“Gravity is always pulling down on planes. To explain a plane crash, you have to explain what happened to the factors that had previously counteracted that downward pull. Why did gravity yank the plane down to earth when it did and not before?

Similarly, businesses are always seeking profit and are always ready to raise prices if that is what will maximize profits. To explain precipitous price hikes, you have to explain what happened to the factors that had previously put a lid on that upward price pressure. Why did profit-seeking propel prices skyward recently and not in 2019?”

“Greed” did not spike suddenly, but something else did. The last two years saw a massive increase in the money supply.

Due to the pandemic and the ensuing lockdowns, production has been drastically throttled over the last three years. This has reduced the number of goods and services readily available. But the amount of money available has precipitously increased, stimulating demand. Naturally, the only way for businesses to compensate for the increase in demand is to raise prices.

These facile takes from Warren and Reich underscore why Hazlitt emphasized that the definition of inflation should remain confined to credit and money supply expansion. By defining inflation as any increase in the price level, it obscures the cause. Rising prices due to a devaluation of currency are very different from supply and demand shocks of goods. Conflating the different causes of price increases leads to the wrong solutions on its cure, such as blaming company greed.

The Cantillon Effect

Now that we are clear on what inflation is, we can explore how inflation diverts as well as hurts.

When the state expands the credit and money supply, it redistributes purchasing power and causes the misallocation of resources in the market. In that redistribution, there are necessarily winners who are able to purchase more and losers who are able to purchase less. This is called the Cantillon effect, named after Richard Cantillon (1680-1734) who first observed that money creation has uneven effects in the market.

When the state prints and spends money or makes money available to lenders, the government and the early recipients of the new money benefit. But that gain necessarily comes at the expense of others, because the new money has not produced any additional real wealth. As Ludwig von Mises explained:

“When the increase of money proceeds by way of issue of currency notes or inconvertible bank-notes, at first only certain economic agents benefit and the additional quantity of money only spreads gradually through the whole community. If, for example, there is an issue of paper money in time of war, the new notes will first go into the pockets of the war contractors. As a result, these persons’ demands for certain articles will increase and so also the price and the sale of these articles, but especially in so far as they are luxury articles. Thus the position of the producers of these articles will be improved, their demand for other commodities will also increase, and thus the increase of prices and sales will go on, distributing itself over a constantly augmented number of articles, until at last it has reached them all. In this case, as before, there are those who gain by inflation and those who lose by it. The sooner anybody is in a position to adjust his money income to its new value, the more favorable will the process be for him.” [emphasis added]

Wars provide a great example of the Cantillon effect, where newly injected money causes a rise in prices for war supplies (benefitting manufacturers such as Lockheed Martin), which redirects the allocation of resources from consumer goods to weapons of war. Every weapon bought through printed money represents a redirection of resources away from the individual to the war. 

The redirected resources include, not only land and capital, but labor, too. The government employs the brightest scientists of the day to design weapons of destruction, instead of allowing them to make new discoveries that would benefit all mankind. Also lost are the innovations and technologies the people would have made if their lives hadn’t been lost or disrupted, and the industry advancements that would have taken place had they not been redirected to producing weapons of war for their country.

Wars are incredibly expensive and immensely unpopular, which is why politicians generally prefer to print money to fund them. “Inflation is in effect a hidden tax,” Thomas Sowell wrote. “The money that people have saved is robbed of part of its purchasing power, which is quietly transferred to the government that issues new money.” Importantly, this hidden tax allows the state to circumvent the public’s protestations against wars, and allow its priorities to take precedence.

Perhaps if wars were funded strictly through taxes, there would be fewer wars in the world.


As has been demonstrated, when the government prints money to fund its projects, it is essentially leeching wealth from everyone else while also making its priorities take precedence, usurping the market democracy.

Yet, this great power to print money and place the state’s priorities ahead of others does not go unnoticed.

During the great recession of 2008, Roger Congleton found that financial firms such as Goldman Sachs, Morgan Stanley, etc., all formally became banks in order to gain access to the Fed’s new safety nets that would relieve them of risky securities. Benjamin Blau found that banks that had lobbied for five years before the great recession were 36 percent more likely to receive emergency loans than banks who hadn’t lobbied.

More recently, BlackRock has been selected by the Fed to “run purchases of corporate bonds and commercial mortgages that are part of its [the Federal Reserve’s] response to the pandemic-led recession.” BlackRock is allowed to buy some of its own funds on behalf of the Fed, while also charging the Fed a management fee of $8 million per year.

The way money is created is of the utmost importance, for the original recipients of money benefit the most. Clearly, businesses have an incentive to be close to the money spigot to maximize their benefits and minimize their losses. The logical conclusion of this fact is that the Fed can never operate as a neutral party, disinterestedly optimizing the market.

Now it is clear that inflation is not only the devaluation of money that causes the prices of goods like Oreos to rise. It also redirects resources with some winners and losers, and it allows the politicians’ priorities to take precedence over individuals within the market. It’s a dangerous tool that rewards the businesses that collude with the state at the expense of everyone else.