What You Should Know About Inflation

During Henry Hazlitt’s tenure as a business columnist for Newsweek, he was frequently asked by his readers for an explanation of the cause of inflation and how they might protect themselves from its continual erosion of their savings.  What You Should Know About Inflation is the result of those requests.  Although first published in 1960, the book is every bit as readable and valid today as it was then.

In order to begin a discussion of the topic, it is necessary to first define what the term inflation actually means.  The correct definition is an increase in a nation’s supply of money and credit.  In more recent times it has become informal practice to refer to inflation as a general rise in prices.  Hazlitt, however, points out that the two meanings are not equivalent, and the failure to grasp this distinction inevitably leads to confusing cause with effect.  Inflation, in its proper definition, is almost always the result of government’s monetary and fiscal policies.

Hazlitt spends a considerable amount of time debunking the popular scapegoats of inflation.  Cost push inflation, wage-price spirals, the need to match money supply to productivity increases, etc. all fall under the scrutiny of logic and historical data.  Through this reiteration of basic principles the reader ultimately develops and intuitive understanding of what inflation is and what it isn’t.  And that often times, what is popularly expressed as the cause of inflation is rather just a consequence of it.

A general rise in prices is the result of an increase in the supply of money and credit.  The solution then is to simply stop the expansion of money and credit.  As simple as it is to say, it is far more difficult to implement in practice.  To do so would require politicians to retract many of the gifts from the government that they used to garner votes in the first place.  It is this government profligacy that is one of the main sources of credit expansion.

Most of the nation’s money supply does not exist in the form of physical currency, but rather as bank accounts against which checks can be written.  When the government cannot pay its bills through direct taxation alone, the Treasury covers the shortfall by issuing bonds.  Bonds sold directly to individuals who pay for them out of savings are not inflationary as they use existing money.  However, many of the bonds are sold directly to banks or the Federal Reserve.  Banks do not use existing money to fund these purchases, rather they inflate the money supply by creating new credit in an account for the Treasury to draw against.

Fiscal deficits are one source of inflation.  Policies by the Federal Reserve to keep interest rates artificially low are another.  Banks don’t just create credit out of thin air when they loan to the Treasury, they do it when they loan to everyone.  The problem with interest rates being held below market rates is that it impairs the judgment of borrowers and encourages them to take on loans they normally wouldn’t.  Eventually households become over-indebted and businesses engage in unsustainable expansions – all of which is inflationary via the creation of new banking credit.  This excess borrowing must ultimately result in the writing off of bad debts and liquidation of malinvestments.  A recession then is the result of a period of inflation.

A great benefit of reading a book about inflation written a half a century ago is the perspective it provides on our current policies.  Through many historical examples, Hazlitt demonstrates that inflation, via deficit spending, is simply what unrestricted governments tend to do.  He makes the prediction that our own policy of inflation and increasing government debt will continue unabated until there is a return to a gold standard.  A freely redeemable gold exchange limits government abuse of the money.  If holders of Dollars begin to lose confidence in the actions of the government, they simply trade their paper money in for gold.  The threat of a run on the Treasury’s gold quickly forces the government to change its policies.  So far, the fifty years of subsequent history have not proven Hazlitt wrong.

The great danger of inflationary policies is that there exists a tipping point at which the loss of purchasing power and confidence begins to accelerate out of control.  Since psychology and perception play a large role in determining that point, it is impossible to know where it lays ahead of time.  And once started, the rapid erosion of a currency’s value is very difficult to halt.

High inflation brings with it a whole host of problems.  A reduced standard of living for much of the population is just the beginning.  High inflation also distorts the factors of production that are used by business to allocate capital.  A profit in nominal terms may not be a profit at all in real terms.  Businesses may invest in areas that are actually causing them to lose purchasing power.  Savers are punished for living within their means and forced to become speculators in an effort to preserve what they have earned.  The entire system of optimized production begins to come apart as no one can accurately know the true value of goods and services or what they are likely to be worth in the future.

Perhaps the greatest danger of all in an accelerating inflationary environment is the government’s response to control the very problem it created.  Wage and price controls, and the inevitable shortages that follow, only lead to frustration and anger.  Continued efforts to contain unrest have led more than one nation into tyranny.  As Hazlitt points out, we can stop inflation and its destructive effects anytime we want – but nothing can happen until individuals accept the responsibility of educating themselves and those around them as to its real causes.