All Commentary
Wednesday, May 1, 1985

Some Evils of Inflation

To be ignorant of inflation is to suffer its evil effects. Most people define inflation as a period of generally rising prices and wages. They echo official pronouncements and news reports by the public media that interpret all price rises as inflationary. Quick to indict anyone who raises prices, they accusingly point to the lust and greed of other men, especially businessmen, as the root cause of inflation.
This popular interpretation of inflation contains all the futile means and remedies commonly used to fight inflation: the price constraints and controls designed to keep prices lower than they otherwise would be, the public condemnation of businessmen who raise prices and their prosecution for violating price control edicts, the imposition of income-tax surcharges, and so forth. It obscures economic reality, pointing at the visible effects of inflation and its victims; it does not call attention to the essence of inflation, the inflating of the money quantity.

The popular confusion about the meaning of inflation is more than just unfamiliarity with its definition. It is a root cause of inflation itself without which it could not persist. It completely reverses cause-and-effect relationships and thereby indicts the victims for perpetrating the crime while it exculpates the monetary authorities who willfully and openly are creating ever more money.

Thought makes the word, and the word makes thought. Inflation breeds great evil, whether you define it as rising goods prices, as an increase in available currency and credit, or as an abnormal increase beyond available goods, resulting in a visible rise in prices. Of all injustice, inflation is one of the greatest as it devours the possessions of millions of hard-working people. And no matter who is perpetrating it, the courts of law actively collaborate with the perpetrators by upholding the evil and declaring it constitutional, equitable and fair. A dollar is a dollar, they proclaim, you shall accept a 10-cent dollar in payment of a 100-cent debt.

Political Injustice

It is easier to endure the losses that are suffered as a result of error and misjudgment than the damage sustained by injustice. Inflation ministers unbearable injustice, defrauding some people and enriching others. It impoverishes some social classes while it bestows comfort and wealth on others. There cannot be any doubt that inflation derives aid and comfort from its many beneficiaries.

Political injustice is committed from a great many motives and reasons, and often makes use of legislation that goes under the name of legal tender, a perfectly innocent label for hideous wrongs. It appears to be harmless, indeed, when defined as “a currency which may be lawfully tendered and offered in payment of money debts and which may not be refused by creditors.” In reality, legal tender is no offer at all, but a forced acceptance. There is no tender that may be freely refused, but a legal obligation to accept a currency no matter how much its purchasing power has fallen or is expected to fall. Legal tender actually denies the freedom of contract and the right to refuse acceptance of deteriorated means of payment.

Legal tender legislation grants government unlimited power over the monetary affairs of the people just as the coinage monopoly of the state did in antiquity and the feudalization of the coinage right during the Middle Ages. It creates this power in democratic societies as it does in the command societies under socialism and communism. Government, by way of legal tender legislation, forces people to accept its own currency, grants it monopolistic position, and prohibits its discount no matter how it may depreciate. In short, legal tender legislation outlaws monetary freedom and paves the way for great injustice.

It is difficult to fathom anything more unjust than legal tender legislation. It permits monetary authorities to inflate and depreciate their money and then force the people to accept it at face value and in full payment. It gives special privilege not only to the government but also to all debtors. They need not pay their debts in full but can discharge them by giving inferior money in exchange. Legal tender destroys the property rights of creditors. Under the pretense of creating order and stability, it turns every credit transaction into speculation on the future purchasing power of the medium of payment. It is immoral to the highest degree.

Legal tender legislation permits government to tax its people without having to seek their consent first. It enables government to issue any quantity of fiat money, declare it legal tender, and spend it for political ends. It is a tool of expropriation of property owners and creditors, including all sellers of goods, services, and labor. It forces them to accept legal tender currency at face value no matter how much it has deteriorated and how low its purchasing power has fallen.

The legal tender evil has come to the U.S. through both legislation and jurisdiction. Under the plea of absolute necessity, the Continental Dollar was made legal tender in 1776 until its demise in March of 1781. During the Civil War, Union greenbacks were given legal tender force. In 1933 all Federal Reserve notes and U.S. Treasury currency were given coercive powers. In every case, the courts sanctioned the action and ignored the evils. The U.S. Supreme Court confirmed the monetary powers of government in a number of conspicuous decisions. From John Marshall, Chief Justice for 35 years (1801-1835), to Charles Evans Hughes, Chief Justice during President Roosevelt’s monetary machinations, most justices made the best of government control over the peo-pie’s money. On June 5, 1933, a Joint Congressional Resolution voided the “gold clause” in all contracts and obligations. In 1935 the Supreme Court concurred. In the words of Chief Justice Hughes, “parties cannot remove their transactions from the reach of dominant constitutional power.” (Henry Mark Holzer, Government’s Money Monopoly, New York: Books in Focus, 1981, p. 185.)

Unearned Income and Loss

Inflation causes displacements in the distribution of income and property. As lenders and borrowers, most people do not take into account variations in the objective exchange value of money. If the monetary value should decline, the lenders are bound to suffer losses in purchasing power while the borrowers gain a corresponding amount. There are long-term contracts that do not have to be fulfilled until a later point in time. There are long-term employment contracts or contracts for the supply of materials, all of which involve money payments over time. They all face inflationary risks.

It is a popular, although erroneous, belief that inflation affects only wealthy individuals because they are said to be the money lenders. This may have been true during the Middle Ages, when economic wealth was concentrated with a few wealthy noblemen and merchants while the masses of people were struggling for mere survival. But ever since the nations of the West emerged from feudalism and mercantilism, and tried individual freedom and enterprise, an ever-growing number of people were able to save some part of their rising incomes, permitting most people to become lenders on net balance. There are millions of creditors of life insurance companies, pension funds, savings banks, and similar institutions. Millions of people own government savings bonds and other money assets. It is true, they may have charge accounts and other consumer debt. But in most cases, savings probably exceed obligations, which suggests the conclusion that the American people are vitally interested in sound money.

The disastrous nature of inflation becomes apparent when we contemplate the magnitude of the losses which inflation is inflicting on millions of American creditors every year. Even at the modest rate of five percent annual depreciation, the annual losses to creditors and gains to debtors amount to more than $100 billion a year. The economic and psychological impact of this silent transfer of wealth on millions of individuals surpasses all imagination.

Considering such staggering losses on the part of the thrifty and provident, the rising clamor for entitlement and transfer is not surprising. The losses strengthen the demand for social security, aged health care, and governmental controls over prices and rents. They foster Federal aid and subsidies and otherwise provide a chief argument for an extension of government power.

Long-Term Contracts

Long-term employment contracts permit inflation to inflict painful losses on millions of working people. Within a few years of employment, they may lose a part of their purchasing-power income through monetary depreciation. Their relative economic and social position in society may decline when inflation ravishes them more than others. There cannot be any doubt that teachers, ministers, priests, and rabbis are primary victims of inflation. But they also are thought leaders who significantly affect the moral, political, and economic trends of the future. Their losses in income and social position during the age of inflation may have contributed to the fact that many are more frustrated in political and economic outlook than other groups of society.

Monetary depreciation inflicts special losses also on industries that are controlled politically—in particular, public utilities. Being subject to commission control, their rates are fixed by decree in accordance with authoritative judgments of fairness and adequacy; but their costs keep on rising in reaction to inflationary pressures. American railroads and public utilities are eminent examples. In competition with other industries for capital, labor, and supplies, their costs are rising. But their own rates are determined by government committees and commissions that are known to grant relief only after lengthy public hearings and long after inflation has raised production costs. Moreover, public authorities are tempted to “fight” inflation and “hold the line” by denying price adjustments. Squeezed by the vise of rising costs and rigid rates, the financial position of public utilities deteriorates considerably. In the end, they stagnate and cease to function efficiently.

Booms and Busts

It is the course of every evil that it brings forth more evil. Unbeknownst to most people, including most economists, inflation breeds business cycles with destructive booms and depressions. Indeed, what has been more damaging to individual freedom and the enterprise system than the recurrence of recessions and depressions! During the Great Depression, government interventionism made its greatest strides. Each new recession gives new impetus to political power.

Inflation at first produces conditions that appear favorable to everyone. Businessmen earn extraordinary profits; there are few, if any, business failures. Employment conditions improve and wage rates rise, for which labor unions and allied politicians loudly claim credit. The general atmosphere is one of confidence and prosperity until the inflation-induced activity tends to raise business costs. In time, costs soar until profits turn into losses and a recession takes the place of the boom.

Recession is a time for readjustment to the demands of the market. Loss-inflicting operations are abandoned and business costs are reduced. Businessmen correct their mistakes made during the boom; the worst offenders are forced to sell out or face liquidation and bankruptcy. Even labor may need to readjust to market demands or face unemployment. In short, a recession or depression is a time of recovery from the excesses and blunders of the boom.

Business cycles have plagued this country from its beginning. In every cycle, the U.S. government tried its hand in money and banking. Whether the debauchery of the Continental Dollar by the Continental Congress, the issue of U.S. Treasury obligations during the British–American War and the Civil War, the financial adventures of the First and Second Banks of the United States, the silver legislation, the World War I inflation—they all constituted preludes for the depressions that followed. Similarly, the Great Depression had its beginnings in the bursts of credit expansion by the Federal Reserve System in 1924-25 and again in 1927-28. Without them, there could have been no stock market boom and no crash of October 24, 1929. Since World War II, Federal Reserve credit expansion has kindled seven booms and seven recessions.

Full employment through deficit spending and currency expansion is the official doctrine that guides the economic policies of Federal Administrations. Whether it is deficit financing or easy bank credit, the ultimate consequences are always the same. But each depression is bound to be deeper and more painful than the preceding one, and each boom more feverish than the preceding boom, because maladjustment, if not corrected, is cumulative. Recessions turn into depressions and booms into “crack-up booms” with panicky flights into gold and other real values. In the end, booms and depressions become “stagflations” that combine both evils: the destruction of currency and the depression with mass unemployment.

Rising Tax Exactions

The federal government is the greatest beneficiary of inflation; politicians, government officials, and their protégés are its greatest profiteers. When inflation raises money incomes, it lifts taxpayers into progressively higher income tax brackets and thus allocates an increasing share of their incomes to government. It pushes them all toward the top rate. Similarly, it boosts government exactions through state and local income taxes, corporate income taxes, estate taxes, and other levies with progression features.

Business income and taxation are especially affected by monetary depreciation. When prices rise, a distortion in profits takes place. They are made to appear larger than they actually are. Inflation drives the cost of replacing plant and equipment above the original cost, but for tax purposes, government recognizes only the original costs and thus forces businesses to overstate their actual earnings. It levies income taxes on imaginary profits which, in reality, are inflationary costs of maintenance.

The great popularity of inflation rests on its benefits to government. The federal government as a giant debtor reaps vast fortunes from monetary depreciation. On its nearly two-trillion-dollar debt it reaps gains of tens of billions of dollars every year. It may add new debt through budgetary deficits, and yet, the mountain of debt, in terms of purchasing power, may not rise at all because inflation may melt it away even faster.

In a modern transfer system, government exists for the purpose of promoting the prosperity of those who run it—politicians and officials. Inflation permits them to spend vast amounts that directly and indirectly benefit them. Their remuneration usually exceeds the amount they can earn in productive employment. Their perks and fringes are much to be desired, their power over others to be feared. In order to secure their benefits and sustain their power, they need the votes of their constituents. Multi-billion-dollar expenditures for group entitlements may buy the votes. And the power to buy votes with entitlement legislation depends on their power to inflate. Without it, a Federal deficit of $200 billion annually would be inconceivable, as would be the myriad of transfer programs and the huge bureaucracy administering the programs. The transfer state builds on the power to tax and to inflate, the effects of which in turn give rise to ever more transfer demands.

The Dollar Standard

Inflation creates problems not only at home but also abroad. Until 1971, when gold was the international money and the U.S. dollar was payable in gold, inflation generally caused an outflow of gold from the country with the highest rate of inflation. Threatening inability to pay in gold tended to restrain the country from inflating any further or force it to devalue its currency toward gold. But in 1971, the United States refused to honor its growing foreign obligations to redeem its currency in gold. Fearing more losses, President Nixon declared gold to be “unsuited for use as money,” and vowed to remove gold from the monetary system of the world. When other major countries followed suit, the transition from the traditional gold standard to irredeemable paper issues was completed.

The U.S. dollar emerged as the primary international currency, serving trade and commerce the world over. It already had acquired a leading position under the Bretton Woods system that had made the U.S. dollar the international reserve money payable in gold at a price of $35 per ounce. When, in August 1971, President Nixon repudiated the agreement, the world continued to use the U.S. dollar without its redeemability. After all, the world’s merchants and bankers had grown accustomed to it. It afforded access to the markets of the most productive country in the world, and its record of relative stability was one of the best in recent monetary history despite its devaluations in 1934 and 1971. But above all, the official repudiation of gold created a void which no other fiat currency could possibly fill. It left the U.S. dollar in the most prominent position for becoming the world medium of exchange and reserve asset.

The world desperately needs a common money that facilitates foreign trade and international transactions. For hundreds of years, gold served as the universal money uniting the world in peaceful cooperation and trade. Today the U.S. dollar is called upon to assume the very functions of gold. But in contrast to the gold standard, which was rather independent of any one government, the dollar standard depends completely upon the wisdom and discretion of the U.S. government. That is, the world monetary standard now rests solely on the political forces that shape the monetary policies of a single country—the United States.

We can think of no greater responsibility for any country than that of the United States to the world. Every day assumes a fearful responsibility when we view the fate of the free world that rests on the U.S. But unfortunately, the dollar standard is a political standard in which the purest motives are mixed with the most sordid interests and fiercest passions of the electorate. The dollar standard itself is the outgrowth of an ideology that placed government in charge of the national monetary order. It is the handiwork of governments and their apparatus of politics. To expect much of such a creation is to invite bitter disappointment.

The world fiat standard leads to temptations which no contemporary government can be expected to resist. The world demand for a reserve currency constitutes an extraordinary demand that tends to support and strengthen its purchasing power. It affords the country of issue a rare opportunity to inflate its currency and export its inflation without immediately suffering the dire consequences of currency debasement. In particular, it presents an opportunity to the administration in power to indulge in massive deficit spending, which hopefully bolsters its popularity with the electorate, while its inflation is exported to all corners of the world. The country that provides the world reserve asset can, for a while, live comfortably beyond its means, enjoy massive imports from abroad while it is exporting its newly-created money in payment of such imports. In short, it can raise its level of living at the expense of the rest of the world.

Government as Beneficiary

For more than a decade, the U.S. government has been the beneficiary of this ominous situation. It engages in massive deficit spending and currency expansion with minimal inflationary effects, as the dollar inflation is exported to foreign countries. For several years, the foreign dollar holders even financed most of the budgetary deficits which the U.S. government was incurring. Inevitably, they suffered staggering losses on their dollar holdings which they had earned in exchange for real wealth. And yet, they are coming back again and again because their own currencies are worse than the U.S. dollar.

The greatest factor of dollar strength is the chronic weakness of other currencies. Leading European currencies do poorly in foreign exchange markets because their banks of issue are pursuing policies of easy money and credit. European central banks are undermining confidence in European currencies and thereby generating an extraordinary demand for U.S. dollars.

The exchange rate between various currencies is determined by their purchasing power. It is explained by the purchasing-power parity theory, according to which the rate of exchange between currencies tends to adjust to their purchasing powers. If the exchange rate were to deviate from parity and a discrepancy were to appear, it would become profitable to buy one and sell the other until the discrepancy would disappear. If the exchange rate of the U.S. dollar versus the Swiss franc were to favor the U.S. dollar it would be profitable to sell the dollar and buy the franc until the disparity would disappear.

Foreign-exchange rate changes anticipate relative changes in goods prices. But it is safe to assume that a rise in foreign exchange rates is unlikely to signal an anticipated rise in purchasing power. After all, in this age of inflation, every currency is losing purchasing power most of the time. “Strength” in foreign exchange rates merely means relative strength in terms of other currencies that are losing purchasing power even faster. The U.S. dollar may be the strongest currency around although it, too, is losing purchasing power. It may rise to spectacular heights versus other currencies, although it is sinking to new lows in purchasing power.

Exporting Inflation

Foreign inflation is giving the dollar a boost; every foreign attempt at prosperity through credit expansion is giving it new strength. On the other hand, every U.S. government effort at expansion is sapping the dollar strength, every new attempt at financial stimulation through Federal Reserve credit expansion is weakening the dollar vis-à-vis all other currencies.

U.S. monetary authorities now are orchestrating the international flow of funds. During the 1970s they generated the greatest credit boom the world has ever seen. There had been some credit expansion before August 15, 1971, when President Nixon unilaterally abolished the last vestiges of the gold standard. But it accelerated dramatically thereafter when the U.S. government showered the world with U.S. dollars. Central bank reserves consisting primarily of paper dollars expanded from $92 billion in 1970 to more than $800 billion in 1983. The Eurodollar market, which recycles the flood of petrodollar deposits to debtors all over the globe, grew from some $100 billion in 1970 to nearly $2 trillion today. All these credits fueled an inflation the likes of which the world has never seen before.

The 1979 Crisis

In October 1979 an international flight from the dollar visibly shook the world dollar standard and cast serious doubt on its future. It forced President Carter to raise $30 billion in harder currencies in order to stem the panic. When the discount rate was raised to 13 percent, the crisis subsided. Federal Reserve authorities subsequently reduced the expansion rate and, in some months, even abstained from any further credit expansion, which soon triggered the beginning of painful readjustment. The 1981-1982 recession was the inevitable effect of this new self-restraint. It precipitated a worldwide scramble for liquidity and gave rise to a “crisis-demand” for U.S. dollars. The demand gave new strength to dollar exchange rates and new support to its purchasing power.

The recession put a heavy strain on the world’s banking system. A number of large debtor countries were unable to meet their obligations. Poland, which owed large debts to financial institutions in the West, fell victim to its own socialistic policies. Argentina, mismanaged by a military junta, sought a rescheduling of its considerable debt. Mexico, in a similar situation, gave rise to the fear that her failure could lead to a chain reaction bringing about a collapse of several large financial institutions and, eventually, the world banking system. Throughout the fears, strains, and volatile changes in foreign exchange markets, the U.S. dollar was gaining in strength.

The crisis demand for dollars was bolstered further by the fears of political and financial instability abroad, making the U.S. dollar a “refuge currency.” In many countries suffering from sustained currency depreciations the U.S. dollar is the key currency. It can be found in the cash holdings of people everywhere who use it as their unit of calculation and medium of exchange. They are bidding for U.S. dollars by offering their goods and services in exchange for more dollars.

As long as individuals the world over are willing to hold dollars and keep on adding dollars, the dollar is bound to remain strong. But if they should lose faith in U.S. policies and reduce their holdings, the dollar would turn weak again, perhaps weaker than ever before. It could tumble in an abrupt and disorderly fashion, and the dollar standard disintegrate in confusion and disarray.

  • Hans F. Sennholz (1922-2007) was Ludwig von Mises' first PhD student in the United States. He taught economics at Grove City College, 1956–1992, having been hired as department chair upon arrival. After he retired, he became president of the Foundation for Economic Education, 1992–1997.