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In view of the
ongoing international financial and economic "crisis," many
investors increasingly ask, Is higher inflation inevitable?[1] At first glance, this question appears
to be rhetorical. Technically speaking, inflation can of course be prevented.
Inflation is,
in the economic sense, an increase in the money supply, which leads (and
necessarily so) to a decline in the purchasing power of money as compared to
a situation in which the money supply remains unchanged.
Today,
government-sponsored central banks hold a money-production monopoly. So all it
takes to end (and prevent) inflation is for central banks to stop expanding
the money supply.
At second
glance, however, the question of whether higher inflation is inevitable may
be somewhat more difficult to answer. This is because of the economic and
political consequences that ending decades-long increases in the money supply
through central banking will entail.
To better
understand these consequences, some insight into the nature and workings of
today's monetary regime is required. Milton
Friedman, in Money Mischief, provides the following
portrayal:
A world
monetary system has emerged that has no historical precedent: a system in which
every major currency in the world is … on an irredeemable paper money
standard.[2]
And further,
"The ultimate consequences of this development are shrouded in uncertainty."[3]
Friedman draws
our attention to the fact that today's monies — be they the US dollar,
the euro, the Chinese renminbi or the British pound
— are so-called fiat monies, with the term fiat ("let it be
done" in Latin) denoting intrinsically valueless money.
Fiat money
(some call it paper money, or political money) has
three major characteristics. First, it is produced under monopoly power held
by the government-sponsored central bank.
Second, fiat
money is typically created through bank-credit expansion. Whenever extending
credit to firms, private households, and government, banks increase the stock
of money. In that sense, today's fiat money is credit money.
And third,
fiat money causes (and inevitably so) economic disequilibria — the
notorious boom-and-bust cycles — and the rise of overall debt exceeding
the growth of incomes. These aspects will be explained in more detail below.
II.
For many great
thinkers, fiat money has a bad rap. For instance, the view that "paper
money eventually returns to its intrinsic value — zero" is
typically attributed to the French philosopher Voltaire (1694–1778).
The American
economist Frank A. Fetter (1863–1949) wrote in Modern Economic Problems that fiat money
is peculiarly liable to be the subject of political intrigue and of popular
misunderstanding. It is this danger, more than anything else,
that makes political money in general a poor kind of money.[4]
Also, Irving
Fisher (1867–1947), in The Purchasing Power of Money, wrote,
"Irredeemable paper money has almost invariably proved a curse to the
country employing it."[5]
Against these
manifold warnings it appears particularly remarkable that fiat monies have
been established the world over, and that fiat money is even widely seen
these days as a state-of-the-art monetary regime.
Economists of
the Austrian School hold a rather different view, though. Their work deserves
particular attention in this context, as they have developed perhaps the most
detailed theory of the role of fiat money for the trade cycle, inflation, and
political developments.
So what did
the presumably most important representatives of the Austrian School — Ludwig
von Mises (1881–1973) and Friedrich
August von Hayek (1899–1992) — have to say about fiat
money?
They found that
the injection of fiat money through bank credit expansion[6] lowers the market interest rate to
below the natural rate level — as the Swedish economist J.G.
Knut Wicksell (1851–1926) called
it — that is, the interest rate that would prevail had the credit and
money supply not been artificially increased.
The
artificially suppressed interest rate makes firms increasingly shift scarce
resources into more time-consuming production processes for capital goods at
the expense of production processes for consumer goods, causing intertemporal distortions of the economy's production
structure, leading to malinvestment.
Fiat-money
injection increases consumption out of current income at the expense of
savings, and, in addition, leads to higher investment, so that the economy
enters an inflationary boom, living beyond its means.
If the
injection of fiat money created through bank-circulation credit out of thin
air were a one-off affair, it presumably wouldn't take long for the
artificial boom to unwind. A recession would restore the economy to
equilibrium as people returned to their truly desired
consumption-savings-investment relation (as determined by time
preference).
In a
fiat-money regime, however, increases in credit and money are not a
one-off affair. As soon as signs of recession appear on the horizon, public
opinion calls for countermeasures, and central banks try their best to
"fight the crisis" by increasing the fiat-money supply through
bank-circulation-credit expansion, thereby bringing interest rates to even
lower levels.
In other
words, monetary policy — usually to the great applause of mainstream
economists — fights the correction of the problem by recourse to the
very action that has caused the debacle in the first place.
Such a
strategy cannot be pursued indefinitely, though. When credit expansion comes
to a shrieking halt — that is, when banks refrain from lending —
the inevitable adjustment unfolds. Borrowers default, and firms liquidate
unsound investments and cut jobs.
And the longer
an artificial credit-money boom had been kept going through repeated
credit-produced fiat-money injections, the greater will be the malinvestments that must be corrected, and the
higher will be output and employment losses.
This is so
because repeated injections of fiat money through bank-circulation-credit
expansion have two consequences. First, they prevent unprofitable investments
from being liquidated. Instead, lower interest rates seemingly return
unprofitable investment to profitability, as they can be refinanced at lower
interest rates.
Second, the
artificially suppressed interest rates encourage additional investments
— investments that would not have been undertaken if the market
interest hadn't been pushed downward by central-bank actions.
As a
consequence, the economy's overall debt load keeps growing at a faster rate
over time than real incomes do, leading to a situation of overindebtedness.
This process is of course accompanied by the piling up of massive government
debt, which is particularly easy to finance in a fiat-money regime.
Mises knew that
pushing interest rates down to ever-lower levels would not solve the problem,
but instead would lead to even bigger problems:
There is no
means of avoiding the final collapse of a boom brought about by credit
expansion. The alternative is only whether the crisis should come sooner as
the result of a voluntary abandonment of further credit expansion, or later
as a final and total catastrophe of the currency system involved.[7]
Mises's lines imply
both (hyper)inflation and deflation as the potential
outcomes of a fiat-money collapse. (Hyper)inflation would result if
government tries to "print itself out of the mess" it has created,
and deflation from a contraction in the money supply as banks call in
outstanding loans and/or default on their obligations, thereby destroying
(part of) the fiat-money stock.
If one
subscribes to the diagnosis provided by the Austrian School of economics, two
important observations must be made. First, issuing more bank-circulation
credit and fiat money at even-lower interest rates will not, and cannot,
solve the problem that has been caused by monetary expansion in the first
place.
Second —
and this aspect may not attract attention right away — governments'
ongoing attempts to fight the economic correction by recourse to
interventionist policies (such as regulation, prohibitions etc.) will
increasingly undermine the free-market order.
This is
something that cannot, and should not, be taken lightly, as free markets are
at the heart of economic prosperity. Free markets allow for productive and
peaceful economic cooperation nationally and internationally. Suppressing
them would therefore come at a fairly heavy price.
III.
The severity
of the ongoing international monetary crisis is epitomized perhaps best by a
growing debate about monetary reform. For instance, the International
Monetary Fund, in February 2011, called for a wide-ranging reform of the
international monetary system.[8]
"A monetary reform (in one way or
the other) is economically inevitable from the Austrian viewpoint — a
fiat-money regime cannot be upheld indefinitely."
Back in
November 2010, the president of the World Bank, Robert
Zoellik, argued that a successor of what
he calls "Bretton Woods II" would be needed:
The system
should also consider employing gold as an international reference point of
market expectations about inflation, deflation and future currency values.[9]
In March 2009,
Zhou Xiaochuan, governor of the
Peoples' Bank of China, wrote,
The desirable
goal of reforming the international monetary system … is to create an
international reserve currency that is disconnected from individual nations
and is able to remain stable in the long run, thus removing the inherent
deficiencies caused by using credit-based national currencies.[10]
In contrast to
these concepts — which are, and unsurprisingly so, interventionist by
nature — economists from the Austrian School have been putting forward
recommendations and strategies for reforming the monetary system along
free-market principles.
Their
recommendations are driven by the insight that the great financial and
economic crises are not inherent in capitalism, but result from
government interventionism in monetary affairs, most importantly by
monopolizing money production. Hayek put it succinctly in 1976:
The past
instability of the market economy is the consequence of the exclusion of the
most important regulator of the market mechanism, money, from itself being
regulated by the market process.[11]
Austrian
economists are of the opinion — based on elaborate economic-ethical
considerations — that curing the current financial and economic crisis
would require a return to sound money. By "sound money," they mean
money that is compatible with the principles guiding the free-market economy.
Sound money is
free-market money, money that is the result of the free supply of and the
free demand for money. It is money that is produced in unhampered markets
where there are no longer any legal privileges for, for instance, central
banks.
As early as
1953, Ludwig von Mises argued for a return to sound
money by reanchoring the US dollar to gold, based
on a free-market price of gold vis-à-vis fiat money, and abolishing
central banking. Mises favored a gold standard and
100 percent reserve banking.[12]
Hayek, in Denationalization
of Money, argued that one could do even better than returning to
gold, namely by allowing for a competition of currencies. According to Hayek,
all legal-tender laws should be abolished, thereby allowing for money users
free choice for their currency, supplied by producers free to supply money.
The best money, or the best monies, so Hayek would say, would win out.
Murray
N. Rothbard (1926–1995) argued,
actually following Mises's reform concept, for a
return to the gold standard by reanchoring fiat money
to central-bank gold reserves — effectively by raising the price of
gold in terms of fiat-money tickets so that it allows for 100 percent reserve
banking.[13]
IV.
As things
currently stand, the chances that the world monetary system will return to
free-market money — such as a freely chosen gold standard without
central banking — may appear small to many observers. This probably
stems from a number of reasons.
Perhaps most
important of these is that the prevailing ideology in today's mainstream
economics has reduced the numbers of supporters who effectively make a
case for sound money to a tiny group whose voice is easily lost, and
consequently the public may not (yet) be fully aware what it has to gain from
sound money.
In any case,
finding an economically viable solution to the problem at hand is a challenge
that the societies that have adopted fiat money will not, and cannot, escape.
One thing is
certain: Escalating injections of fiat money into the economies is not a
promising policy in terms of restoring the economies back to health. Such
injections would just lead to further debasement of the currency without
solving the underlying root cause of the problem.
What about the
consequences of a market-oriented monetary reform? If government were to
decide to reanchor fiat monies to gold, the outcome
would be a debasement of the currencies if and when the price of gold is set
at a level that results in a rise of the fiat-money stock — which would
be, of course, a rather tempting decision to make if those in government hold
the view that there is "too much" debt around.[14]
Alternatively,
a substantial debasement — or even total erosion — of fiat
money's purchasing power would result if and when the monetary reform is
driven by unhampered market forces in the following way: people start increasingly
to exchange their fiat money (which isn't redeemable into anything) for sound
money media such as gold and silver, thereby driving down the exchange value
of fiat money (even to the disappearing point).
A monetary
reform (in one way or the other) is economically inevitable from the Austrian
viewpoint — a fiat-money regime cannot be upheld indefinitely. As a
result, one would have to conclude that the debasement of existing fiat
monies has become almost inevitable
Thorsten Polleit
Thorsten Polleit is Honorary Professor at
the Frankfurt School of Finance & Management.
This essay was originally published in www.Mises.org. By authorization.
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