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Friday, July 30, 2010

Inflation: Watering Down the Punch

With the recent financial crisis macroeconomic issues are receiving more and more attention. Inflation is one of those issues. Many claim inflation to be the cause of the crisis; which has even given the Austrian business cycle theory attention from the media. The theory states that an increase in the money supply causes a false appearance of savings and thus investment. This leads to mal-investment in certain industries, in the recent crisis it would be the housing market, eventually popping the bubble leading to a recession while the market reallocates resources to their truly valued ends (see here for more).

This clearly seems like a complicated issue but in many ways its actually quite simple. F.A. “Baldy” Harper, an economist from Cornell University who worked for FEE in its first years and then founded the Institute for Humane Studies, wrote this 1951 pamphlet on inflation. For him, “inflation can be prevented. Failure to do so is purely and simply a matter of negligence.” And the way to prevent it is clear, “Inflation means too much money. The way to prevent inflation, then, is to close down the money factory. It is that simple.”

The issue is not how much money the government should print but is an institutional one. Economists define institutions as rules that constrain human behavior. Our current monetary system fails to constrain the government from the over printing of money. Currently the government has a monopoly over the monetary system; as Harper points out, if you don’t believe this just try and make your own money. The government wishes to hold this monopoly in order to cover what it spends in excess of its income, i.e. tax revenue. In essence, inflation is simply a hidden tax on every dollar we hold. The government thus has the incentive to print as much money that will maximize its revenue. It is similar to the government basically having an incentive to consistently water down a bowl of punch.

A monopoly in money essentially boils down to a planned monetary system. As Carl Menger, the founder of the Austrian school of economics, showed money did not emerge from the state but through a spontaneous order brought about by the complex interaction of many individuals. In the past, money, usually gold, was produced through a competitive process. Anyone could produce it. By allowing our monetary system to instead be “planned” by the government we have created what economist Gordon Tullock called a social dilemma. Society would be better off if the government did not inflate the money supply but the government gains from doing it, thus, just like a prisoner’s dilemma, we end up with a non-socially optimal outcome.

Maybe the situation is not as simple as Harper suggests. It is after all no simple task to remove the government monopoly on money. But as Harper points out, we are left with only two options, “the only escape from the consequences of these laws would seem to be for the citizens to ignore them. This means lawlessness, technically, in the form of black market operations and all the other forms of evasion. This places the honest citizen who favors human liberty in a strange dilemma. He must choose between practicing lawlessness in the technical sense, or supporting a socialist-communist regime.” What is simple is that the government has forced planning in our monetary system upon us. This makes Harper’s pamphlet extremely relevant even today.

Download F.A. “Baldy” Harper’s pamphlet on Inflation here.

  • Nicholas Snow is a Visiting Assistant Professor at Kenyon College in the Department of Economics, and previously a Senior Lecturer at The Ohio State University Economics Department. His research focuses on the political economy of prohibition.