The Mirage of Inflation   3 comments

The art of economics consists in looking not merely at the immediate, but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group, but for all groups.

This is an ongoing series of posts on Henry Hazlitt’s Economics in One Lesson. You can access the Table of Contents here. Although written in 1946, it still touches on many of the issues we face in 2017, particularly the fallacies government economic programs are built upon.
The most obvious and yet the oldest and most stubborn error on which the appeal of inflation rests is that of confusing “money” with wealth.

That wealth consists in money, or in gold and silver,” wrote Adam Smith more than two centuries ago, is a popular notion which naturally arises from the double function of money, as the instrument of commerce, and as the measure of value. . . .

To grow rich is to get money; and wealth and money are considered synonymous. Real wealth consists in what is produced and consumed: the food we eat, the clothes we wear, the houses we live in. It is railways, roads, and cars; ships, planes, factories; schools, churches and theaters; pianos, paintings, and books.

Yet so powerful is the verbal ambiguity that confuses money with wealth, that even those who at times recognize the confusion will slide back into it in the course of their reasoning. Each man sees that if he personally had more money he could buy more
things from others. If he had twice as much money he could buy twice as many things; if he had three times as much money he would be “worth” three times as much. And to many the conclusion seems obvious that if the government merely issued more money and distributed it to everybody, we should all be that much richer.

Image result for image of inflationThese are the most naive inflationists, but there is a second group that is less naive, that senses there is a catch somewhere. They would limit in some way the amount of additional money they would have the government issue. They would have it print just enough to make up some alleged “deficiency” or “gap.” We call that “quantative easing” in the 21st century.

This second group reasons that purchasing power is chronically deficient because industry somehow does not distribute enough money to producers to enable them to buy back, as consumers, the product that is made. There mysterious leakage somewhere. There’s evena  group of economists who “prove” this by equations. On one side of their equations they count an item only once; on the other side they unknowingly count the same item several
times over. This produces an alarming gap between what they call “A payments” and what they call “A+B payments.”

So they found a movement, put on green uniforms, and insist that the government
issue money or “credits” to make good the missing B payments. The cruder apostles of “social credit” may seem ridiculous; but there are an indefinite number of schools of only slightly more sophisticated inflationists who have “scientific” plans to issue just enough additional money or credit to fill some alleged chronic or periodic “deficiency” or “gap” which they calculate in some other way.

There’s a third group — more knowing inflationists — who recognize that any substantial
increase in the quantity of money will reduce the purchasing power of each individual monetary unit, causing an increase in commodity prices. They aren’t disturbed by this. They actually want this sort of inflation because they believe it improves the position of debtors compared to reditors. Others believe will stimulate exports and discourage imports. Still others think it is an essential measure to cure a depression, to “start industry going again,” and to achieve “full employment.”

Image result for image of inflationThere are innumerable theories concerning the way in which increased quantities of money (including bank credit) affect prices. Some imagine that the quantity of money could be increased by almost any amount without affecting prices. They merely see this increased money as a means of increasing everyone’s “purchasing power,” in the sense of
enabling everybody to buy more goods than before. Maybe they never paused to consider that people cannot buy twice as much goods as before unless twice as much goods are produced. Maybe they fail to recognize the shortages of manpower, working hours, productive capacity or raw materials as a limitation on production and believe that is merely a shortage of monetary demand that prevents people from purchasing goods that don’t exist yet.

There are some eminent economists who hold a rigid mechanical theory of the effect of the supply of money on commodity prices. They believe the value of the total quantity of money multiplied by its “velocity of circulation” must always be equal to the value of the total quantity of goods bought. Multiply the quantity of money n times, in short, and you must multiply the prices of goods n times.

There is not space here to explain all the fallacies in this plausible picture. Instead we shall try to see just why and how an increase in the quantity of money raises prices.


Let’s say the government makes larger expenditures than it can or wishes to meet out of the proceeds of taxes or the sale of bonds paid for by the people out of actual savings. For example, the government prints money to pay war contractors.

Image result for image of inflationThe first effect of these expenditures is to raise the prices of supplies used in war and to put additional money into the hands of war contractors and their employees. The war contractors and their employees now have higher money incomes, which they can spend for goods and services they want. The sellers of these goods and services will be able
to raise their prices because of this increased demand. Those who have the increased money income will be willing to pay these higher prices rather than do without the goods; for they will have more money, and a dollar will have a smaller subjective value in the eyes of each of them.

So Group A (the war contractors and their employees) buys goods and services from Group B (those who produce those goods and services). Group B, as a result of higher sales and prices, will now buy more goods and services from Group C. Group C in turn will be able to raise its prices and will have more income to spend on group D. Okay, point taken. Circle of life. When the process has been completed, nearly everybody will have a higher income measured in terms of money. But (assuming that production of goods and services has not increased) prices of goods and services will have increased correspondingly; and the nation will be no richer than before.
This does not mean that everyone’s relative or absolute wealth and income will remain the same as before. The process of inflation will affect different groups to a greater or lesser extent. The first groups to receive the additional money will benefit most. The money incomes of Group A will have increased before prices have increased, so that they
will be able to buy almost a proportionate increase in goods. The money incomes of Group B will advance later, when prices have already increased somewhat; but Group B will also be better off in terms of goods. In the meantime, the groups that have still had no advance in their money incomes will find themselves forced to pay higher prices for the things they buy.

Let’s say we divide the community arbitrarily into four main groups of producers, A, B, C, and D, who get the money-income benefit of the inflation in that order. When the money incomes of Group A have already increased 30 percent, the prices of the things they [urchase have not yet increased at all. By the time money incomes of Group B have increased 20 percent, prices have still increased an average of only 10 percent. When money incomes of Group C have increased only 10 percent, however, prices have already gone up 15 percent. It gets worse. Although they money incomes of Group D have not yet increased, the average prices they have to pay for the things they buy have gone
up 20 percent.

In other words, the gains of the first groups of producers to benefit by higher prices or wages from the inflation are necessarily at the expense of the losses suffered (as consumers) by the last groups of producers that are able to raise their prices or wages.

It may be that, if the inflation is brought to a halt after a few years, the final result will be an average increase of 25 percent in money incomes, and an average increase in prices of an equal amount, both of which are fairly distributed among all groups. This does not cancel out the gains and losses of the transition period. Group D even though its own incomes and prices have at last advanced 25 percent, will be able to buy only as much goods and services as before the inflation started. It will never compensate for its losses during the period when its income and prices were lagging.
Inflation turns out to be merely one more example of our central lesson. “The art of economics consists in looking not merely at the immediate, but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group, but for all groups.”

It may indeed bring benefits for a short time to favored groups, but only at the expense of others. In the long run it brings disastrous consequences to the whole community. Even a relatively mild inflation distorts the structure of production, leading to the over-expansion of some industries at the expense of others in a misapplication and waste of capital. When the inflation collapses, or is brought to a halt, the misdirected capital investment—whether in the form of machines, factories, or office buildings—cannot
yield an adequate return and loses the greater part of its value.

Nor is it possible to bring inflation to a smooth and gentle stop in order to avert a subsequent depression. It is not even possible to halt an inflation, once embarked upon, at some preconceived point, or when prices have achieved a previously-agreed-upon level; for both political and economic forces will have got out of hand.

You cannot make an argument for a 25 percent advance in prices by inflation without
someone’s contending that the argument is twice as good for an advance of 50 percent, and someone else’s adding that it is four times as good for an advance of 100 percent. The political pressure groups that have benefited from the inflation will insist upon its continuance.

It is also impossible to control the value of money under inflation because the causation if not a merely mechanical one. You cannot say in advance that a 100 percent increase in the quantity of money will mean a 50 percent fall in the value of the monetary unit. The value of money depends on the subjective valuations of the people who hold it.

All this explains why, when super-inflation has once set in, the value of the monetary unit drops at a far faster rate than the quantity of money either is or can be increased. When this stage is reached, the disaster is nearly complete; and the scheme is bankrupt. Yet the ardor for inflation never dies. It would almost seem as if no country is capable of profiting from the experience of another and no generation of learning from the sufferings of its forbears. Each generation and country follows the same mirage. Each grasps for the same Dead Sea fruit that turns to dust and ashes in its mouth. For it is the nature of inflation to give birth to a thousand illusions.

In Hazlitt’s day as in our own, the most persistent argument put forward for inflation (uh, quantative easing) is that it will “get the wheels of industry turning” and save us from the irretrievable losses of stagnation and idleness, bringing “full employment.”

This argument in its cruder form rests on the immemorial confusion between money and real wealth.

It assumes new “purchasing power” is being created, and that the
effects of this new purchasing power multiply themselves in ever-widening
circles. Just look at the ripples!

The real purchasing power for goods consists of other goods. It cannot be wondrously increased merely by printing more pieces of paper called dollars. Fundamentally what happens in an exchange economy is that the things that A produces are exchanged for the things that B produces.

What inflation really does is to change the relationships of prices and costs. It is designed to raise the price of commodities in relation to wage rates and so restore business profits, by encouraging a resumption of output where idle resources exist, by restoring a workable relationship between prices and costs of production.

Historically this was done by a reduction in wage rates, but proponents of inflation believe that this is now politically impossible. Some go so far as to say reductions in wages are “anti-labor” or against the poor. Yet what they propose deceives labor by reducing real wage rates through an increase in prices. They disingenuously talk about paper money is if it were a form of wealth that can be created by will at the printing press.  They even solemnly discuss a “multiplier,” by which every dollar printed and spent by the
government becomes magically the equivalent of several dollars added to the wealth of the country. Like magicians, they divert attention from the real causes of any existing depression.

The real causes, Hazlitt said, are usually mal-adjustments within the wage-cost-price structure — maladjustments between wages and prices, between prices of raw materials and prices of finished goods, or between one price and another, or one wage and another. At some point these maladjustments have removed the incentive to produce, or have made it actually impossible for production to continue; and through the organic
interdependence of our exchange economy, depression spreads. Not
until these mal-adjustments are corrected can full production and
employment be resumed.

True, inflation may sometimes correct them; but it is a heady and dangerous method. It makes its corrections not openly and honestly, but by the use of illusion.

Hazlitt actually touched on the daylight savings time manipulation.

For inflation throws a veil of illusion over every economic process. It confuses and deceives almost everyone, including even those who suffer by it. We are all accustomed to measuring our income and wealth in terms of money. The mental habit is so strong that even professional economists and statisticians cannot consistently break it.

Economic reality is sometimes hard to understand. Who among us does not feel richer and prouder when we hear that our national income has doubled compared with some pre-inflationary period?

Inflation is the autosuggestion, the hypnotism, the anesthetic, that has dulled the pain of the operation for him. Inflation is the opium of the people.

Because inflation confuses everything is the reason “planned economy” governments resort to it. We saw in chapter 14, to take but one example, that the belief that public works necessarily create new jobs is false. If the money was raised by taxation, we saw, then for every dollar that the government spent on public works one less dollar
was spent by the taxpayers to meet their own wants, and for every public job created one private job was destroyed.
Suppose the public works were not paid for from the proceeds of  taxation? Suppose they are paid for by deficit financing—that is, from the proceeds of government borrowing or from resorting to the printing press? Then the result just described does not seem to take place. The public works seem to be created out of “new” purchasing power. You cannot say that the purchasing power has been taken away from the taxpayers. In the short-term, the nation seems to have got something for nothing.
Then we look at the long-term reality. The borrowing must someday be repaid. The government cannot keep piling up debt indefinitely. That leads to bankruptcy. As Adam Smith observed in 1776:

When national debts have once been accumulated to a certain degree, there is scarce, I believe, a single instance of their having been fairly and completely paid. The liberation of the public revenue, if it has ever been brought about at all, has always been brought about by a bankruptcy; sometimes by an avowed one, but always by a real one, though frequently by a pretended payment.

Of course, for government to repay the debt it has accumulated for public works or war or whatever, it must necessarily tax more heavily than it spends. When it is time to pay the piper, it must necessarily destroy more jobs than it creates. The extra heavy taxation then required does not merely take away purchasing power; it also lowers incentives to production, and so reduces the total wealth and income of the country.
The only escape from this conclusion is to assume in true Keysenian form, that the politicians in power will spend money only in what would otherwise have been depressed or “deflationary” periods, and will promptly pay the debt off in what
would otherwise have been boom or “inflationary” periods.

This is a beguiling fiction, but unfortunately the politicians in power have never acted that way. Economic forecasting, moreover, is so precarious, and the political pressures at work are of such a nature, that governments are unlikely ever to act that way. Deficit spending, once embarked upon, creates powerful vested interests which demand its continuance under all conditions.

The country as a whole cannot get anything without paying for it. If no honest attempt is made to pay off the accumulated debt, and outright inflation is resorted to instead, then inflation becomes a form of taxation, which bears hardest on those least able to pay. Inflation is tantamount to a flat sales tax of the same percentage on all commodities,
with the rate as high on bread and milk as on diamonds and furs.
It can also be thought of as equivalent to a flat tax of the same percentage, without exemptions, on everyone’s income. It is a tax not only on every individual’s expenditures, but on his savings account, life insurance and retirement.

It is a flat capital levy, without exemptions, in which the poor man pays as high a percentage as the rich man.

Of course, that is assuming inflation affects everyone equally, which it rarely does. Some suffer more than others. The poor may be more heavily taxed by inflation, in percentage
terms, than the rich.

For inflation is a kind of tax that is out of control of the tax authorities. It strikes wantonly in all directions. The rate of tax imposed by inflation is not a fixed one: it cannot be determined in advance. We know what it is today; we do not know what it will be tomorrow; and tomorrow we shall not know what it will be on the day after.

Of course, like every other tax, inflation determines the individual and business policies we are all forced to follow. It discourages all prudence and thrift, encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce.

It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse.

Posted February 9, 2017 by aurorawatcherak in economics, Uncategorized

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3 responses to “The Mirage of Inflation

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  1. Pingback: Introduction to “Economics in One Lesson” | aurorawatcherak

  2. Popped by to thank you for the follow – and found this! A bit heavy going for this late on a Friday – but the gist agrees 100% with my own understanding of Economics. Wealth is not the same as ‘loadsa money’. I lived through the mid-1970s inflation in the UK. ’75 >’76 my salary increased by 30% but its purchasing power was less.


    • Thanks for your comment. Most people don’t seem to understand that you’re a millionaire if you have a million dollars in net worth. If you’re in retirement, that’s called a comfortable nest egg. If you’re living on 6% of that, like anyone who expects to live 30 years after retirement should, that’s living on only $94,000 a year. While that’s still a nice living, it’s not “wealthy” by any means.


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