Dr. Sennholz heads the Department of Economics at Grove City College and is a noted writer and lecturer on monetary and economic affairs.
It has been said that affliction is a school of virtue, that it corrects levity and interrupts the confidence of sinning. If this should be true, then the rampant inflation which is our most serious public affliction should offer important lessons in virtue and hamper the confidence of economic sinning. But such lessons cannot be learned as long as ignorance deprives man of some basic understanding of his affliction and of the remedies there are.
For hundreds of years the issue of excessive quantities of paper currency by government was called inflation. Rising goods prices were deemed to result inevitably from such issues and were thought to offer an indication or measure of the degree of monetary inflation. But in the semantic confusion of our age we are calling the rise in prices inflation. And the issuer of the money, spendthrift government, is called “inflation fighter.”
How delightful and profitable for officials and politicians! They can spend and spend without much worry about budget deficits, which are covered by the issue of new currency. The new terminology implicitly lays the blame for rising prices on anyone who dares to raise his prices, on “greedy” businessmen and workers, speculators and foreigners. But the confusion brings havoc and poverty to countless victims whose incomes are greatly reduced and savings destroyed. It impoverishes the “middle class” with its savings for the rainy day and retirement.
Inflation is sometimes described as a tax on the money holders. In reality, it is a terrible instrument for the redistribution of wealth. It is true, the government is probably its greatest profiteer as its tax revenues are boosted by the built-in progression in higher income brackets and through the depreciation of governmental debt. But in addition, the inflation shifts wealth from those classes of society who are unable, or do not know how to defend themselves from the monetary destruction, to entrepreneurs and owners of material means of production. It strengthens the position of some businessmen while it lowers the real wages of most working men and professionals. It decimates or destroys altogether the middle class of investors who own securities or hold claims to life insurance and pension payments. And finally, it gives birth to a new middle class of traders, speculators, and small profiteers of the monetary depreciation.
Massive Redistribution
The magnitude of the present redistributive process in the U.S. can only be surmised. Let us estimate the total volume of public and private debt at $2.7 trillion (Federal $475 billion, state and local government $200 billion, corporations $1150 billion, farms $80 billion, residential mortgages $400 billion, commercial mortgages $75 billion, other commercial debt $55 billion, financial debt $65 billion, consumer debt $195 billion). A ten per cent rate of dollar depreciation transfers $270 billion a year from the creditors to the debtors. A fifteen per cent rate, which better reflects economic reality, would transfer $405 billion per year. Now, disposable personal income in the U.S. is estimated at $931 billion (cf. Federal Reserve Bulletin, July 1974, p. 57), which makes the inflation transfer income and loss nearly 44 per cent of annual incomes from productive services. In short, present inflation as a powerful instrument of wealth redistribution is responsible for a stream of income and loss equal to almost one half of our productive efforts.
The redistribution process is also a massive debt liquidation process in real terms. Surely, the nominal magnitude of dollar debt is rising, but in terms of real things and real values debt is being liquidated at the depreciation rate. A ten per cent rate of currency depreciation reduces real debt by ten per cent; total monetary destruction destroys debt totally. It transfers the ownership of real wealth from the people who have lent money to the people who have borrowed the money.
Such are the profits and losses from only one source: the currency depreciation that gives to debtors that which it takes from creditors. In addition, several other inflation factors inflict huge losses on nearly all classes of society.
Rampant inflation destroys the capital markets which are the very well-spring of productive enterprise. Having suffered staggering losses through depreciation, few lenders are able to grant new loans to finance business expansion or modernization, or merely current operation. And even if they had the funds, they are reluctant to enter monetary contracts for any length of time. Business capital, especially long-term loan capital, becomes very scarce, which precipitates economic stagnation and recession. Similarly, businessmen begin to hedge for survival, investing their working capital in inventory and capital goods. Funds that used to serve consumers become fixed investments in capital goods that may escape the monetary depreciation. Economic output, especially for consumers, thus tends to decline, which may raise goods prices even further.
A great deal of “unproductive” labor is needed to cope with the complexities of calculation and dealing with rapidly changing prices. Cost accounting faces the insoluble task of calculating business costs with a yardstick that is shrinking continually. Managerial decisions become very difficult and enterprise efficiency is greatly hampered, which raises business costs and reduces output.
Finally, the greatest danger to economic production and well-being looms in sudden government intervention. Having recklessly depreciated the currency at two-digit rates, the same government may want to legislate and regulate the economic actions of the people. It may suddenly impose price, wage, and rent controls, restrict imports or exports, levy new taxes, or commit some other folly, all in order to treat some symptoms of its own policies.
Real Wages Fall
Two-digit inflation tends to reduce the real wages of nearly all classes of employees, from unskilled laborers to chief executives. While many goods prices can be adjusted quickly to the monetary depreciation, wage and salary contracts are written for longer periods of time, often for a year or even longer. During this time employees suffer a continuous erosion of real incomes and standards of living. It is true, the reduction in real wages, which are business costs, tends to raise the demand for labor, which generally causes unemployment to decline. Also, profitable enterprises that continue to compete aggressively for labor tend to review wages and salaries more often than before, for instance, every six months instead of waiting two years. Others boost merit pay substantially to avoid rising costs through higher turnover.
The general decline in real wages tends to breed widespread labor unrest. Individual productivity may fall substantially which raises business costs, reduces output and thus boosts prices even further. Labor unions react by demanding large increases in nominal wages, and sometimes may succeed in restoring real wages at least temporarily, until the inflation again reduces real wages, followed by further union demands, and so on. Ugly strikes multiply, costing millions in work hours, inflicting business losses and raising costs, and thus generating ever greater pressures for higher prices. In desperation many millions of heretofore unorganized employees are led to joining unions or forming collective strike organizations in order to avert the loss of real wages. Labor unions seem to thrive on monetary depreciation and the economic conflict it generates.
Rampant inflation also affords growing popularity and public support of a system of wages based on a cost-of-living index, commonly called indexation. All wages may be fixed according to an index number calculated by a government bureau. Of course, even such a system cannot be expected to protect labor from the disastrous influences of monetary depreciation as the index is calculated on the basis of past prices that differ from goods prices when wages are paid and spent. General indexation of wages also works havoc upon those industries that suffer severely from the inflation, such as consumers’ goods industries and service industries. They may contract further, reducing output and service, which again raises prices.
The Poor Suffer
The poorest classes of society living closest to the subsistence minimum are hurt most severely by monetary depreciation. Especially those poor who live on fixed incomes, such as pensions and annuities or welfare gratuities that are slow to adjust to the rise in prices, may actually experience deprivation and hunger. Others may be forced to supplement their shrinking purchasing power by seeking employment if this should be possible. Thus, some unskilled labor that used to prefer public support over working for a living will return to productive employment. Others may resort to vice and crime to bolster their falling incomes.
Real incomes of civil servants, military personnel, and salaried employees of commerce and industry may fall even faster than those of the poor. True, they may not immediately face deprivation and hunger, but they may be greatly reduced and impoverished by the rise in goods prices that tends to exceed their occasional salary adjustments.
The situation may even be worse with professional men, such as physicians and dentists, attorneys, artists, writers, and professors at private institutions of learning. Rampant inflation may reduce them to a life of penury and misery as public demand for their professional services tends to decline significantly with the general impoverishment of the populace. After all, demand for their services is much more elastic than that for food, for instance, which explains why less money is spent on professional services in spite of ever larger government expenditures on health, education and welfare.
The suffering of this professional class is compounded by the destruction of its savings through inflation. In general, the middle class generates the financial capital that affords productivity and expansion to commerce and industry. It holds a large share of national wealth in the form of financial capital, such as corporate stock and debentures, demand and time deposits, life insurance, pension funds, and the like, all of which suffer serious losses from the depreciation of the currency. In fact, rampant inflation expropriates the wealth and substance of this middle class.
Dangerous Stock Markets
The stock market offers great opportunities during periods of rampant inflation. Industrial shares especially are subject to extreme fluctuations in price, which astute traders will use to their advantage. This does not mean that the market offers investors a reliable hedge against inflation. On the contrary, the real value of shares tends to decline, which inflicts considerable depreciation losses on share owners. But alert traders can profit from the many chills and fevers that attack the market.
The greatest factor of change that virtually shapes the price trends is the monetary policy of government. Large bursts of money creation and credit expansion are followed by sudden jerks of restraint or even stability, which trigger symptoms of economic recession and decline. Or, the government may suddenly impose price, wage and rent controls, or resort to other means of intervention that temporarily reverse the trend. To ignore the ever-changing signals of monetary policy and other government intervention can be very costly.
In terms of purchasing power, stock prices tend to decline because most business profits are more apparent than real. The sums set aside for maintenance of equipment, called depreciation, are mostly insufficient. Replacement costs soar while depreciation that is allowable under the tax laws is based on past costs and therefore insufficient to cover present costs. In fact, many profits are fictitious, which causes companies to pay income taxes although there is no income, and declare dividends while working at a loss. Similarly, the inflation profits on inventory are mostly fictitious as replacement costs may equal or even exceed the proceeds of a sale that was believed to be profitable.
During periods of rampant inflation it is very difficult, even for experts, to ascertain the profitability of an enterprise. To interpret profit statements and balance sheets becomes nearly impossible, which affords companies an opportunity to hide their earnings or losses and show only what they want to show. For an investor to appraise the value of his corporate shares becomes an insoluble task.
Occasionally the monetary authorities may slow down or even abstain from creating more currency and credit. Or their rate of expansion may fall short of that expected by businessmen. In each case the fevers of inflation are interspersed with the chills of recession and depression, which send stock and bond prices tumbling until, once again, the Federal Government comes to the rescue with record budget deficits and new bursts of currency expansion. After all, this is the basic recipe of the “new economics” that has shaped Federal economic policy since the 1930′s and has given us “inflationary recessions,” i.e., simultaneous inflation and recession.
No Sure Hedge in Fluctuating Stocks
When one or several of the stated factors depress stock prices the public may realize that even the purchase of industrial securities affords no safe means of investing their savings. Suffering heavy losses, they withdraw from the market and invest their remaining funds in goods or money market instruments, especially Treasury obligations. The public is the “middle class” of some 30 million stockholders and 50 million investors who indirectly own corporate securities through investment companies, pension funds, life insurance companies, credit unions, and so on. They suffer heavy losses when they finally liquidate their stock investments for depreciated currency. It has been estimated that since 1965 most American stock investors have lost at least 40 per cent of their savings through price declines and another 40 per cent through currency depreciation.
From time to time the fever of inflation may cause stock prices to soar as the monetary authorities refuel the money markets in order to avoid depression and unemployment. The investor may rejoice about his long-awaited profits. Deluded by the apparently high prices he may be induced to sell his securities. Unfortunately he may not be aware of the real losses which the monetary depreciation is inflicting on him. Again he loses severely in purchasing power and real wealth, and yet may have to pay an income tax on the nominal profits he earned.
The speculator who observes the merciless drubbing of most investors has learned to distinguish “apparent profits” from “real” ones. He trades with the trends of the market, jumps from industry to industry, always seeking action and quick profits. But above all, basically he is a buyer of the securities that are liquidated by the middle-class investor. The monetary depreciation which greatly reduces their real price makes it easier to acquire securities. Thus, we can observe not only a gradual shift of corporate wealth from the old class of capitalists and middle-class investors, but also a concentration of industrial shares in fewer and fewer hands. A small new middle class of traders and speculators replaces the old middle class of investors, and huge new fortunes are created from the losses suffered by investors and capitalists.
The depreciation of public debt and the fall of industrial securities in terms of both price and purchasing power strike a devastating blow not only at millions of small investors but also at great capitalists whose wealth is invested in marketable securities. Wealthy stock brokers, bankers, financiers, rentiers, heirs, or businessmen in retirement who before the inflation owned large fortunes, that is the “old rich,” suffer serious losses. Old fortunes vanish, and eminent family names fade away. Similarly, the wealth of charitable institutions, religious societies, scientific or literary foundations, and endowed colleges and universities, is destroyed by inflation.
Losses in Real Estate
While inflation inflicts havoc on monetary investments, it has varied effects on property of land and buildings. Agriculture, on the whole, survives a period of feverish inflation rather well. Farmers generally profit from the increase in prices of agricultural goods and from the depreciation of farm mortgages. Even small and middle-size operators whose debt may render their independence rather precarious in normal times can hold their own during rampant inflation. After all, they are the producers and owners of real goods the prices of which rise, yielding ever higher incomes, while inflation reduces the real burden of their debt.
Ownership of residential housing offers a much poorer defense against inflation than is commonly believed. Although mortgage debt is greatly reduced by the inflation, which affords some inflation profits to owners, the market price of private residences and commercial property usually limps behind the rate of monetary depreciation. During rampant inflation interest rates soar and mortgage loans are hard to find, which makes it rather difficult to finance a purchase. Thus, effective demand may be reduced which tends to depress real estate prices. This is especially true for middle class housing whose owners feel impoverished and in need of retrenchment. It may not be true for beautiful mansions and large estates that continue to sell at high prices to a new class of nouveaux riches.
But even when real estate appreciates in price and the owner gains from a sale, on which he must pay a capital gains tax, he may lose in terms of purchasing power. Deluded by apparently high prices, many owners may be induced to sell their homes, to realize only much later, perhaps, that they made a poor bargain.
The situation is most dangerous and precarious for apartment house owners. They are vulnerable not only to the imponderables of a feverish capital market, to the impoverishment of their working and middle-class tenants, and to the price delusion mentioned above, but also to the ever-present danger of rent control. A desperate government may do desperate things. Drawing wrong conclusions from given facts and fighting symptoms rather than causes, it may by force arrest prices, wages and rents. But rent controls imposed for prolonged periods of inflation reduce real rents significantly, which causes house prices to fall accordingly. With maintenance expenses rising, real rents falling and losses looming, many owners may be forced to sell out — at very low prices. And again, the class of old investors makes room for a new class of speculators who at bargain prices are buying a great many houses.
But even without controls rental property may be depressed because working and middle class demand for housing is shrinking as real income is declining. Or, many apartment house owners may not realize the significance of the monetary depreciation, and therefore are slow to adjust their rents. Or, they may be reluctant to raise rents for charitable reasons. In each case the yield from such property tends to decline, and therefore also real estate prices, which may inflict serious losses on its owners.
The Nouveaux Riches
Huge private fortunes and imposing concentrations of capital are formed from inflationary redistribution. But in contrast to the formation of capital under stable monetary conditions, when fortunes are built through productive changes and improvements, through technological inventions and efficient methods of production, the wealth derived from inflation is “redistributive,” from one individual to another. The new millionaires are not generally creators of new industries or reorganizers of production. They are mostly clever speculators with excellent understanding of monetary policy and its effects on stock prices, exchange rates and high finance. They may even be industrialists who are turning away from the hard work of business management to the more rewarding dealings in securities, commodities and foreign exchange. But above all, they understand the phenomenon of inflation and use this knowledge in all their financial operations.
As speculators they endeavor to render the most urgent economic service needed at the time. They are quick to adjust their resources to the rapid changes in prices and markets that suffer from chronic maladjustments due to the ever-changing monetary scene. Thus they facilitate quicker and smoother readjustment and better allocation of economic resources to the most urgent needs of the public.
During rampant inflation one of the rules of good management is to contract as many productive debts as possible. The speculator borrows other people’s money, which is repaid later with depreciated currency. Instead of keeping large bank deposits he finds it more advantageous to incur the highest possible debt with his bank. Of course, at all times he must maintain his liquidity to meet current obligations, always guarding against sudden calling of loans by his bank in moments of extreme credit stringency.
Inflation not only destroys income and wealth, but also redistributes them from millions of creditors to many debtors. Some businessmen, especially the young, aggressive entrepreneurs, understand this principle and utilize it to their advantage. They expand their enterprises or acquire new ones, merge with others or form new business structures — always building on debt. The inflation losses suffered by banks and bond holders who finance the expansion accrue as profits to these entrepreneurs who join the class of nouveaux riches. But occasionally when the government reverses its monetary policy, when it deflates rather than inflates or when it merely reduces the rate of monetary depreciation, these entrepreneurs may find themselves overextended. They may have to contract their operations, or liquidate some of their holdings. In fact, some may lose their fortunes even faster than they were made.
Chills and Fevers
Financial survival is especially difficult as the fevers of inflation are interspersed with the chills of recession. Some industries may be seized by the inflation fever while others may suffer recession symptoms. Rampant two-digit inflation does not follow the simple pattern of earlier moderate inflation, which tends to generate economic booms that are followed by periods of recession. Instead, it causes such serious disarrangement of markets and disruption of production that both economic disorders occur simultaneously.
The rapid depreciation of the money virtually destroys the capital market. The supply of loan funds tends to shrink as lenders are fearful of suffering losses from the depreciation of the money. Capital-intensive industries and others that depend on long-term financing, therefore lack the necessary capital for expansion, modernization, or merely maintenance of costly capital equipment. The strength and substance of such industries may deteriorate, their capital being gradually consumed. If, in addition, these industries are enmeshed in government rate setting and price fixing, they may wear out quickly, which becomes visible in the deterioration or even breakdown of service. Obviously, the equity markets of these industries tend to be depressed throughout the rampant inflation.
Also consumers goods industries, in general, tend to contract throughout this period. After all, most consumers suffer losses of income and wealth and, therefore, are compelled to curtail the consumption of goods they deem least essential. Vacations may be postponed or at least shortened. Expenditures on entertainment, amusement, and other “luxuries” may be cut. There may even be reductions in the quality of essentials, such as food, clothing, and housing. And instead of seeking education in private institutions, the children may attend public schools, and state or community colleges.
The only industries that thrive on rampant inflation are the capital goods industries. They are producing the goods that permit business to hedge against the inflation through investments in new tools and equipment, or larger inventories of materials and supplies. As inflation reduces the real costs of labor, many businesses endeavor to accumulate capital in the form of durable assets, preferably those that are expected to appreciate in value while retaining some degree of marketability. Many companies use their own working capital or seek bank loans to increase their inventories or add to tools and equipment, which can be expected to rise faster in price than the interest costs on the capital invested. They sacrifice liquidity in the hope of higher profits from the expected rise in prices.
Boom and Bust
All these specific symptoms of rampant inflation tend to conceal the most important predicament that affects everyone: the boom and bust cycle that is generated by the inflation. When the monetary authorities first expand the money supply in order to finance Federal deficit spending or stimulate the economy they set into motion certain forces that seriously distort the allocation of productive resources. Specifically, the policy of easy money and credit temporarily reduces interest rates, which causes businessmen to invest more funds in new construction, machinery, equipment, and raw materials. It generates a feverish boom in the capital goods industries with rapidly rising prices of labor and resources. Now, this boom built on easy money and credit must come to an end as soon as the rising prices of labor and resources, which are business costs, erase profit margins or even inflict losses. After all, the boom must end as it was artificially built on paper and credit only. The recession that follows permits markets to return to normal, in particular, capital goods prices to decline, the industry to contract again, and the consumers goods industries, which were neglected throughout the boom, to come into their own again.
But this cycle can be extended in duration and be made more severe in its fluctuations through new injections of money and credit. Or merely the anticipation of new injections may cause businessmen to reduce their cash-holdings and escape into real goods. Thus, the boom may continue to rage even though the monetary authorities may cease temporarily to add new money and credit, because businessmen have come to expect an early resumption of monetary expansion. Once capital goods prices rise at two-digit rates, a temporary halt in the expansion process does not signal an end of the boom that continues to be fed by businessmen’s reduction in cash holdings. Although interest rates may soar and the costs of financing equipment and inventory rise significantly, capital goods prices are rising even greater. It pays to order and buy now rather than wait until prices have risen again.
The expectation of an early resumption of easy money and credit that keeps the fires of boom burning is solidly based on a political assumption: that government will soon inflate again in order to alleviate some consequences of its earlier inflation. Alarmed about the recession that is engulfing the consumers’ goods industries, it will want to stimulate once again these industries. When consumers are fast losing purchasing power during two-digit inflation, consumers’ goods industries suffer symptoms of contraction and recession, especially unemployment of capital and labor. But by popular demand government is expected to cope with this recession with all means at its disposal. That is, it is expected to resume deficit spending and credit expansion in order to restore full employment. The economic boom thus burns on with new money and credit.
From Bad to Worse
In the ideological climate of today there can be no genuine reversal of monetary policy. The two-digit inflation must rage on, feeding an ever hotter boom of the capital goods industries and aggravating the recession in the consumers’ goods industries. The purchasing power of the dollar must fall at ever faster rates, being depreciated by ever larger injections of money and credit and a growing expectation thereof. Two-digit inflation only comes to an end with the advent of three‑digit inflation which signals the approaching demise of the paper currency. In the final convulsion of inflation fever, millions of housewives join businessmen in a panic rush to exchange their rapidly depreciating money for real goods. When millions of consumers hurry to spend their monetary assets and use all their lines of credit in order to seek refuge in real goods, the end of the currency comes in sight. Consumers’ goods prices that were rising at much lower rates than those of producers’ goods then will soar to catch up with the latter, or even surpass them, in the final contortion of the crack-up boom. In the dusk of the paper system that springs from political power and economic redistribution, the dreaded depression that was so long delayed in coming will finally make its entrance with irresistible force. Thus, once again, the inexorable laws of economics will prevail over political intrigue and power.
Indeed, affliction is a school of virtue that may correct levity and interrupt the confidence of sinning. But how long and how often must man be afflicted before he learns the lesson?