All else remaining equal, an increase in the supply of money will lead to
a decrease in the purchasing-power (price) of money. Furthermore, this is the
only effect of monetary inflation that the average economist or central
banker cares about. Increases in the money supply are therefore generally
considered to be harmless or even beneficial as long as the purchasing-power
of money is perceived to be fairly stable*. However, reduced purchasing-power
for money is not the most important adverse effect of monetary inflation.
If an increase in the supply of money led to a proportional shift in
prices throughout the economy then its consequences would be both easy to see
and not particularly troublesome. Unfortunately, that’s not the way it
happens. What actually happens is that monetary inflation causes changes in
relative prices, with the spending of the first recipients of the
newly-created money determining the prices that rise the first and the most.
Changes in relative prices generate signals that direct investment. The
further these signals are from reality, that is, the more these signals are
distorted by the creation of new money, the more investing errors there will
be and the less productive the economy will become.
Also, although adding to the money supply cannot possibly increase the
economy-wide level of savings, monetary inflation temporarily creates the
impression that there are more savings than is actually the case. This
reduces interest rates, which prompts investments in ventures that are predicated
on unrealistic forecasts of future consumer spending. Again, the eventual
result will be a less productive economy.
During any given year it usually won’t be possible to separate-out the
pernicious effects of monetary inflation and the distortion of interest rates
that goes hand-in-hand with it from all the other forces affecting the
economy. There will simply be too many things going on in the world that
could be influencing the data. However, by taking a wide-angle (that is, long
term) view it will often be possible to see the effects on the economy of
shifts in monetary inflation.
As an example of how long-term shifts in monetary inflation/intervention
can be linked to long-term shifts in economic progress I present the
following chart of the US Industrial Production Index. The chart shows that
the industrial-production growth trend flattened at around the time that the
‘golden shackles’ were removed, that is, at around the time that the Fed was
essentially empowered to do a lot more. This is not a fluke. The chart also
shows that the ramping-up of the Fed’s monetary interventions in 2008-2009
has been followed by the weakest post-recession recovery in at least 70
years. Again, this is not a fluke.
In economics, to have a chance of correctly interpreting cause and effect
in the data you first have to know the right theory. That’s why Keynesian
economists will not link the US industrial production slowdown with the Fed’s
increasingly aggressive monetary interventions. From their perspective, the
only negative effect that monetary inflation can possibly have is to
make the cost of living rise at a faster pace than they believe it
should be rising.
*Stable, here, means rising at around 2% per year. Note that it is not
possible to come up with a single number that represents the economy-wide
purchasing power of money, but this doesn’t stop the government (and some
private organisations and individuals) from doing exactly that.
