Inflation and Recession

foundationsofeconomicsChapter 13 of Shawn Ritenour’s Foundations of Economics marks a significant change in the author’s approach. Up to this point, the discussion of economic phenomena has been purely descriptive. Ritenour follows Ludwig von Mises in arguing that economics as a social science is value-free to the extent that it seeks to understand the laws that govern human action. These laws have an objective quality and cannot be changed because they are built into the structure of creation by God.

However, in Chapter 13 Ritenour enters into a discussion of economic policy, or “action that the state takes in the economy.” Now suddenly we are in a world of “ought” rather than a world of “is,” and thus questions of ethics come into play. Ritenour states that good economic policy must satisfy two criteria: it must seek a proper result, and it must seek that result by proper means. Both an understanding of economic law and a sound moral standard (a Christian one for Ritenour) must be operative.

With this understanding of policy as a context, Ritenour enters a discussion of inflation. Building on the material in the previous chapter, he states that a general rise in prices (what the word “inflation” normally denotes in contemporary usage), or a fall in the PPM, is a result of an increase in the stock of money. In nearly all cases this is brought about by governments, which have monopolized the production of money in the modern world. When money was still defined as a unit of a commodity, governments increased the stock of money through a process called “debasement,” by reducing the quantity of the commodity in the money unit (clipping coins, mixing in base metals with gold/silver/copper coins, or simple redefinition of the money unit). The government forces the populace to accept the debased money through “legal tender” laws and makes a short-term profit (“seigniorage”) on the money commodity it held through the debasement.

Once the use of fiduciary media (e.g., bank notes) became common, the government could also increase the stock of money by increasing the quantity of fiduciary media in circulation. This expansion of paper money often leads to a devaluing of the paper money in comparison to the money commodity when people realize the government does not have enough “real money” to redeem the fiduciary media. Even if the government forbids the populace access to the real money, as the United States did from 1933 to the 1970s, it still must deal with foreign governments seeking to redeem the paper for the commodity. This scenario led to the United States’ repudiating of all obligations to redeem paper dollars for gold in 1971. Since that time we have operated on a pure fiat standard.

Because banks operating on a fractional-reserve basis fear redemption demands for “real money” they have promised to provide but do not have in their vaults, they have an incentive to form cartels which will reduce their risks. Cartel members agree to paper clearing of redemption demands against each other and thus reduce their need for cash. However, the same problems that exist for other cartels exist for bank cartels.

Thus modern banks have tended to favor the existence of a central bank backed by the government that will act as a “lender of last resort” and bail them out when they get into trouble. They also favor the creation of “deposit insurance” in which the government promises to restore the deposits (through the creation of new money, if needed) of people whose savings are in banks that fail. This also reduces the risk of bank runs. Central banks also establish a “required reserve ratio” which regulates how much fiduciary media banks can create, thus protecting them from competition. In the United States, the Federal Reserve performs these functions and also influences the stock of money in the economy through “open market operations,” mainly through the buying or selling of government bonds in the financial markets. When the Fed buys bonds, it does so with newly created money, increasing the stock of money. When it sells bonds, it takes the money it collects out of circulation, thus reducing the stock of money.

So this is how inflation occurs: through an increase in the stock of money created and regulated by the central bank. The consequences of inflation are significant. The rise in prices does not happen all at once, but gradually as the new money works its way through the economy. This means that people who get their hands on the new money first (e.g., banks, governments, government contractors) have a short-term opportunity to make purchases with it before prices rise. Those who get the money last (generally people on fixed incomes, such as pensioners) suffer because they have to pay higher prices before getting of the new money. Additionally, inflation benefits debtors and harms creditors because debts are paid back with money worth less than the money that was originally borrowed. As expectations of higher prices increase, the demand for money and thus the PPM falls even more, and in extreme situations this can result in “hyper-inflation,” or the complete collapse of the money unit, as happened in Germany in 1923 and in Zimbabwe in the 2000s.

The remainder of the chapter explains the Austrian Business Cycle Theory. In a nutshell, governments often desire the effects of economic growth without the necessity of savings and consumption accumulation that make it possible. So through the central bank’s open market operations it forces interest rates to an artificially low level. This low interest rate encourages more borrowing by entrpreneurs looking to start or expand business operations. The expansion of capital spending creates a temporary boom, but the real resources needed to sustain both the long-term projects of entrepreneurs and the current consumption of the populace do not exist. Thus many of these entrepreneurial projects ultimately fail for lack of resources, the result of a “cluster of errors” that would not have occurred absent the artificial lowering of interest rates. These failures bring on the bust. Employment falls, and society must expend much effort to liquidate the bad investments made during the boom. Ritenour states that the bust must be allowed to run its course to clear the decks for sustainable economic growth thereafter; efforts to prop up failed industries will only drag things out.

This post is running long, but I’m sure I’ll have occasion to return to business cycle theory later in this project, so I’ll wrap up here.

About Dr. J


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