All Commentary
Monday, November 1, 1965


What exactly causes inflation and who does it effect the most?

Inflation is one of the most im­portant, yet least understood, is­sues of our day. Contrary to what we might be led to believe by the news media and some high eco­nomic advisors, inflation is not a rise in the general level of prices (often referred to as an increase in the cost of living). Inflation is simply an increase in the supply of money. This increase in the number of dollars in relation to the goods and services that are put up for sale causes people to bid up prices. Thus, a general rise in prices is the effect of inflation. More dollars is the underlying cause of the higher prices.

We first must recognize this cause-effect relationship before we can understand the problems and dangers of inflation. Likewise, once we understand this relation­ship, we can easily see through the fog created by statements like the following, made by high-placed people in our nation, when the in­flation (money expansion) has al­ready taken place!

“Fortunately, we have been free from inflation and the expectation of imminent inflation.”… or “The deficits in the last three years have clearly not been infla­tionary.”

Statements such as these give people the mistaken idea that in­flation and a rise in prices are identical when, in truth, it is in­flation that produces higher prices. It is because Americans have ac­cepted such statements as true that we have engaged in worthless battles to fight rising prices when the real culprit has been an in­flated money supply. In other words, we, like Don Quixote, have become excited about phantom windmills only to leave the real problem untouched. As a doctor would say, we have been trying to cure the fever instead of the ill­ness.

What Causes Inflation?

Expansion of our money supply (inflation) takes place through our banking system. The Federal government can, and does, cause new dollars to be created through IOU’s (bonds) that it issues. This is how the process works:

1. Congress votes to let the gov­ernment spend more money during the year than it will collect in taxes. This authorizes the U. S. Treasury Department to print up enough IOU’s (bonds) to cover the difference between taxes col­lected and the amount of money it will spend. (At this point in­flation has not yet occurred.)Our purchase does not add to the money supply.

The Treasury Department sells these IOU’s through dealers to anyone who will buy them. If you or I buy one of these bonds, this act is not inflationary because we use dollars that we have saved.

In other words, we just transfer dollars that are already in exist­ence. Our purchase does not add to the money supply.

2. But when a commercial bank purchases or loans money on these government IOU’s, new checkbook money can be created because the bank may pay for the bonds by creating a deposit. (It is at this point that inflation actually oc­curs.) In addition, the official re­serve ratio, which is set by the Federal Reserve Board, tends to have a multiplier effect of about six to one on the new money. All this newly created money competes with your dollars and my dollars to buy existing goods and services. It is this increased dollar competi­tion that causes prices to go up.

Some Results of Inflation

As we have just seen, when gov­ernment causes an artificial in­crease in the number of available dollars, the increase tends to re­duce the value of existing dollars. It’s like adding water to lemonade. Volume increases but the lemon­ade becomes weaker, and it takes more of the weaker lemonade to do the same job. But that’s not all that happens. In addition:

1. Inflation insidiously transfers wealth and purchasing power from the pockets of savers to those who borrow. The value of money that has been saved becomes less as dollars become more numerous. Borrowers later can repay their loans with cheaper dollars. This is one way in which government can cause wealth to be secretly transferred from one person to another—a process that must seem unfair to aging persons who have toiled and saved during a lifetime only to have the value of their savings melt away.

Another way in which inflation secretly transfers wealth is that the normal distribution of income is upset. The newly created dollars cause prices and wages to rise first in the areas and industries where the government spends them.Certain people in the economy get government-bestowed advantage over the others. People who first receive the newly created money get a chance to buy goods and services before the inflated money supply causes a general rise in prices. As the new money begins to circulate and causes people to bid up prices, the unfortunate people at the tail-end of this cycle are faced with the problem of paying higher prices before their incomes go up. And when their incomes finally rise, another cycle of inflation and ris­ing prices is already started, so they are always behind. Thus, cer­tain people in the economy get a government-bestowed advantage over the others.

2. Inflation kills the incentive to save. When savers realize that their dollars buy less when paid back after a period of time, they tend to spend their extra dollars instead of saving them. Or, as an alternative, they increase the amount of interest charged to bor­rowers to make up for the future loss of purchasing power. The high rates of interest charged in countries with advanced inflation is an example of this. For in­stance, if the going rate of in­terest is 5 percent, but lenders expect the purchasing power of money to drop by 10 percent during the next year, they will want to charge interest of about 15 percent for use of their money. In other words, as the incentive to save goes down, the cost of inducing people to save goes up.

3. Inflation works to lower our standard of living by reducing the productive capacity of our econ­omy. Our high standard of living in America is supported by our tools of production, the machines that produce our goods and serv­ices. These tools come into being only through self-denial. Someone, many someones, must be willing to save and invest part of their income in productive tools instead of spending it all on consumer goods and services. Thus, if a lack of incentive to save induces people to spend all of their current in­come, worn-out tools aren’t re­placed fast enough. Productive capacity drops, and this brings about a lower standard of living.

People generally aren’t aware of how thin the line is that sep­arates those countries that have progressing economies from those with stagnant or declining econ­omies. An investigation will show that the so-called underdeveloped nations are the ones where people have not had the needed motiva­tion to save part of their incomes for investment in tools of produc­tion. Thus, these nations have economies whose productive capac­ities can’t catch up with their booming populations. The United States could easily find itself in the same spot if our people were led to reducing substantially the percentage of their incomes that is saved. And the difference be­tween these countries and the United States is the motivation that individuals have to save.

4. Inflation causes boom-bust cycles like we saw in 1924-38. At first, inflation produces conditions that seem favorable to everyone. Profits go up because selling prices tend to keep ahead of business costs for a while. This induces businessmen to increase plant in­vestment, which causes employ­ment to expand. Wages start go­ing up, fewer businesses fail, and people generally come to believe that the key to continual prosperity has been found. But then demand for the various factors of produc­tion—land, labor, and capital—goes up. This increased demand causes their prices to rise. And these prices are business costs. As business costs rise, profits go down, plant investment is cut back, and employment drops. This is the “bust” half of the earlier “boom.” This readjustment lasts until costs come down and busi­ness activity again becomes prof­itable.

5. Inflation distorts business re­sults, which is one reason for the above boom-bust cycle. Real profits aren’t nearly as big as they appear because they are overstated. Part of a company’s reported profit (the amount it pays taxes on) is only “paper profit” and must be si­phoned off and put with its de­preciation allowance to buy higher-priced equipment as old machines wear out. If the company didn’t use part of its profit to do this, its productivity tools would gradu­ally become so old and worn out that it could no longer compete in the marketplace. It would lose money and finally be forced out of business.

In addition, fluctuating price-cost relationships make it more difficult for a company’s cost ac­countants to accurately evaluate the profitability of interlocking business operations. Thus, early losses are not noticed, and needed business adjustments are delayed. This delay causes a less effective use of resources which increases costs.

6. Inflation promotes greater intervention in the economy. As inflation-produced recessions get underway, business gets blamed for the downturn, and people turn to government for help. They mis­takenly hope that government can come up with quick and painless solutions for the very economic problems that government caused in the first place! Business still carries an undeserved stigma for the Great Depression of the 1930′s.Inflation hurts people of modest means most.

The resulting governmental in­tervention leads to price, wage, and other controls that reduce in­dividual freedom and initiative. These controls further complicate private enterprise activities, and an endless chain of controls is un­derway. The result is a continued centralization of power in the Fed­eral government, such as we are seeing today.

7. Inflation hurts people of mod­est means (the working man) most. It is “the little guy” who is the net creditor in our society and who gets hurt during the “boom” as well as in the “bust.” When prices rise, his dollars—which are mostly invested in savings ac­counts, insurance, and other fixed-dollar assets—lose purchasing power.

When the “bust” finally comes and he is put out of work, his relatively small dollar savings might not be enough to enable him to meet loan payments on his home or car. Thus, he runs a grave risk of losing his built-up equity to the financial institutions that loaned him the money to buy them.

8. Inflation paves the way for dictatorial control of a nation in much the same way that Hitler and Mussolini rose to power forty years ago. It divides people into conflicting factions. Instead of vol­untarily cooperating to solve im­portant problems, various groups tend to become antagonistic toward each other.

The end result of continued in­flation is to weaken a nation in every respect: Its economic and social structure, its productive ca­pacity, and the standard of living of its people. Thus is a country’s economy disrupted and made ripe for easy takeover.

More effects of inflation could be cited, but they all point in one direction: to the final concentra­tion of all power in the central government. This dangerous tend­ency can be reversed if we rec­ognize that long-term expansion of our money supply can be brought about only through the Federal government and its agen­cy, the Federal Reserve System. Thus, our government must be held responsible for inflation—though we, as citizens, remain fi­nally accountable for what we allow our government to do.