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A. Inflation and Credit Expansion

In chapter 11, we depicted the workings of the monetary system of a purely free market. A free money market adopts specie, either gold or silver or both parallel, as the “standard” or money proper. Units of money are simply units of weight of the money-stuff. The total stock of the money commodity increases with new production (mining) and decreases from wear and tear and use in industrial employments. Generally, there will be a gradual secular rise in the money stock, with effects as analyzed above. The wealth of some people will increase and of others will decline, and no social usefulness will accrue from an increased supply of money—in its monetary use. However, an increased stock will raise the social standard of living and well-being by further satisfying nonmonetary demands for the monetary metal.

Intervention in this money market usually takes the form of issuing pseudo warehouse receipts as money-substitutes. As we saw in chapter 11, demand liabilities such as deposits or paper notes may come into use in a free market, but may equal only the actual value, or weight, of the specie deposited. The demand liabilities are then genuine warehouse receipts, or true money certificates, and they pass on the market as representatives of the actual money, i.e., as money-substitutes. Pseudo warehouse receipts are those issued in excess of the actual weight of specie on deposit. Naturally, their issue can be a very lucrative business. Looking like the genuine certificates, they serve also as money-substitutes, even though not covered by specie. They are fraudulent, because they promise to redeem in specie at face value, a promise that could not possibly be met were all the deposit-holders to ask for their own property at the same time. Only the complacency and ignorance of the public permit the situation to continue.105

Broadly, such intervention may be effected either by the government or by private individuals and firms in their role as “banks” or money-warehouses. The process of issuing pseudo warehouse receipts or, more exactly, the process of issuing money beyond any increase in the stock of specie, may be called inflation.106 A contraction in the money supply outstanding over any period (aside from a possible net decrease in specie) may be called deflation. Clearly, inflation is the primary event and the primary purpose of monetary intervention. There can be no deflation without an inflation having occurred in some previous period of time. A priori, almost all intervention will be inflationary. For not only must all monetary intervention begin with inflation; the great gain to be derived from inflation comes from the issuer's putting new money into circulation. The profit is practically costless, because, while all other people must either sell goods and services and buy or mine gold, the government or the commercial banks are literally creating money out of thin air. They do not have to buy it. Any profit from the use of this magical money is clear gain to the issuers.

As happens when new specie enters the market, the issue of “uncovered” money-substitutes also has a diffusion effect: the first receivers of the new money gain the most, the next gain slightly less, etc., until the midpoint is reached, and then each receiver loses more and more as he waits for the new money. For the first individuals’ selling prices soar while buying prices remain almost the same; but later, buying prices have risen while selling prices remain unchanged. A crucial circumstance, however, differentiates this from the case of increasing specie. The new paper or new demand deposits have no social function whatever; they do not demonstrably benefit some without injuring others in the market society. The increasing money supply is only a social waste and can only advantage some at the expense of others. And the benefits and burdens are distributed as just outlined: the early-comers gaining at the expense of later-comers. Certainly, the business and consumer borrowers from the bank—its clientele—benefit greatly from the new money (at least in the short run), since they are the ones who first receive it.

If inflation is any increase in the supply of money not matched by an increase in the gold or silver stock available, the method of inflation just depicted is called credit expansion—the creation of new money-substitutes, entering the economy on the credit market. As will be seen below, while credit expansion by a bank seems far more sober and respectable than outright spending of new money, it actually has far graver consequences for the economic system, consequences which most people would find especially undesirable. This inflationary credit is called circulating credit, as distinguished from the lending of saved funds— called commodity credit. In this book, the term “credit expansion” will apply only to increases in circulating credit.


Most of these gains and losses will be “short-run” or “one-shot”; they will occur during the process of inflation, but will cease after the new monetary equilibrium is reached. The inflators make their gains, but after the new money supply has been diffused throughout the economy, the inflationary gains and losses are ended. However, as we have seen in chapter 11, there are also permanent gains and losses resulting from inflation. For the new monetary equilibrium will not simply be the old one multiplied in all relations and quantities by the addition to the money supply. This was an assumption that the old “quantity theory” economists made. The valuations of the individuals making temporary gains and losses will differ. Therefore, each individual will react differently to his gains and losses and alter his relative spending patterns accordingly. Moreover, the new money will form a high ratio to the existing cash balance of some and a low ratio to that of others, and the result will be a variety of changes in spending patterns. Therefore, all prices will not have increased uniformly in the new equilibrium; the purchasing power of the monetary unit has fallen, but not equiproportionally over the entire array of exchange-values. Since some prices have risen more than others, therefore, some people will be permanent gainers, and some permanent losers, from the inflation.107

Particularly hard hit by an inflation, of course, are the relatively “fixed” income groups, who end their losses only after a long period or not at all. Pensioners and annuitants who have contracted for a fixed money income are examples of permanent as well as short-run losers. Life insurance benefits are permanently slashed. Conservative anti-inflationists’ complaints about “the widows and orphans” have often been ridiculed, but they are no laughing matter nevertheless. For it is precisely the widows and orphans who bear a main part of the brunt of inflation.108 Also suffering losses are creditors who have already extended their loans and find it too late to charge a purchasing-power premium on their interest rates.

Inflation also changes the market's consumption/investment ratio. Superficially, it seems that credit expansion greatly increases capital, for the new money enters the market as equivalent to new savings for lending. Since the new “bank money” is apparently added to the supply of savings on the credit market, businesses can now borrow at a lower rate of interest; hence inflationary credit expansion seems to offer the ideal escape from time preference, as well as an inexhaustible fount of added capital. Actually, this effect is illusory. On the contrary, inflation reduces saving and investment, thus lowering society's standard of living. It may even cause large-scale capital consumption. In the first place, as we just have seen, existing creditors are injured. This will tend to discourage lending in the future and thereby discourage saving-investment. Secondly, as we have seen in chapter 11, the inflationary process inherently yields a purchasing-power profit to the businessman, since he purchases factors and sells them at a later time when all prices are higher. The businessman may thus keep abreast of the price increase (we are here exempting from variations in price increases the terms-of-trade component), neither losing nor gaining from the inflation. But business accounting is traditionally geared to a world where the value of the monetary unit is stable. Capital goods purchased are entered in the asset column “at cost,” i.e., at the price paid for them. When the firm later sells the product, the extra inflationary gain is not really a gain at all; for it must be absorbed in purchasing the replaced capital good at a higher price. Inflation, therefore, tricks the businessman: it destroys one of his main signposts and leads him to believe that he has gained extra profits when he is just able to replace capital. Hence, he will undoubtedly be tempted to consume out of these profits and thereby unwittingly consume capital as well. Thus, inflation tends at once to repress saving-investment and to cause consumption of capital.

The accounting error stemming from inflation has other economic consequences. The firms with the greatest degree of error will be those with capital equipment bought more preponderantly when prices were lowest. If the inflation has been going on for a while, these will be the firms with the oldest equipment. Their seemingly great profits will attract other firms into the field, and there will be a completely unjustified expansion of investment in a seemingly high-profit area. Conversely, there will be a deficiency of investment elsewhere. Thus, the error distorts the market's system of allocating resources and reduces its effectiveness in satisfying the consumer. The error will also be greatest in those firms with a greater proportion of capital equipment to product, and similar distorting effects will take place through excessive investment in heavily “capitalized” industries, offset by underinvestment elsewhere.109

  • 105. Although it has obvious third-person effects, this type of intervention is essentially binary because the issuer, or intervener, gains at the expense of individual holders of legitimate money. The “lines of force” radiate from the interveners to each of those who suffer losses.
  • 106. Inflation, in this work, is explicitly defined to exclude increases in the stock of specie. While these increases have such similar effects as raising the prices of goods, they also differ sharply in other effects: (a) simple increases in specie do not constitute an intervention in the free market, penalizing one group and subsidizing another; and (b) they do not lead to the processes of the business cycle.
  • 107. Cf. Mises, Theory of Money and Credit, pp. 140–42.
  • 108. The avowed goal of Keynes’ inflationist program was the “euthanasia of the rentier.” Did Keynes realize that he was advocating the not-so-merciful annihilation of some of the most unfit-for-labor groups in the entire population—groups whose marginal value productivity consisted almost exclusively in their savings? Keynes, General Theory, p. 376.
  • 109. For an interesting discussion of some aspects of the accounting error, see W.T. Baxter, “The Accountant's Contribution to the Trade Cycle,” Economica, May, 1955, pp. 99–112. Also see Mises, Theory of Money and Credit, pp. 202–04; and Human Action, pp. 546 f.