Lesson 3

Inflation and Deflation

AUDIO: Inflation, Deflation, and the Future | Frank Shostak

Inflation and Deflation


What is the definition of inflation? Basically there are two ways to define or measure inflation: the increase in the money supply or the price increase of a basket of certain goods. The problem with the latter is that the selection of goods in the basket is arbitrary. Whoever decides which goods are part of the basket influences the resulting inflation rate. Therefore the only objective way to measure inflation is the increase of the money supply. Accordingly deflation is just the opposite of inflation: a decrease in the money supply.

Price inflation of certain goods is a mere consequence of the inflation of money supply. Due to the time difference between the banks’ creation of new money and the distribution of it in the economy through trade prices don’t rise simultaneously with the quantity of money. And because of the individual preferences of the first spenders of the new money prices will not rise uniformly in all markets.

Those who get the additional quantity of money first have the advantage of buying goods before their prices increase. The trade is always money against a certain good. Goods have their latest market price according to the current supply and demand. When the banking system creates new money through credit the debtor buys something with it and pays the current market price. That new purchasing power takes away some of the supply of the good. At the same time demand of the other participants who didn’t get the new money hasn’t changed. With the same demand and less supply of a certain good its price has to rise. Now according to the consumer preferences of the seller the new money leads to a price increase in the next market and so on. This process ends when, after a certain time, the new money is eventually distributed among all markets of the economy bringing about higher prices everywhere.

Savers and receivers of fixed wages bear the costs of inflation, while those spending and receiving the new money first get the benefit.

Within a monetary system like ours money in its essence is credit. Every monetary unit is born as somebody’s liability towards a bank. The debtor has to pay interest for it. Therefore the rest of the economy always owes more money to the banking system than there is money in existence, because of the interest the non-banking sector has to pay for its money units to the banking sector. The existing money supply at a certain time can never be enough to pay the debt plus interest back. Now there are two possibilities: The economy either goes bankrupt or some people raise new credits to pay back their old loans plus interest. The banking sector cannot want the whole economy to go bust because in this case people would vent their anger on the owners of the banks. But if it’s only some individuals who go broke the banks get the tangible assets these people borrowed on as securities for their credits. This system is highly profitable for banks. They either get interest for doing nothing else but adjusting a checkbook entry on the debtor’s account. Or they get the bankruptcy assets. To keep this business model going banks permanently increase the money supply by lending out to an economy that as a matter of principle cannot pay back the interest.

For the private sector to be inclined to getting into debt people have to believe that they will have a good chance to pay back their loans plus interest and to make a profit with their investments in the future. That would be impossible, if there was only the private sector’s borrowing of money as a source of new money flowing into the economy. Money within the private sector would be so scarce that the risk of going bankrupt would be too high for many of the potential debtors. Therefore the public sector as an accumulator of debt and companion of the banks in creating more money is necessary to keep the system alive. Fresh money flowing in from the government’s bank credits is ready to be chased by the private sector and enables it to pay back loans plus interest and make a profit. Via public deficit spending on products of the private sector the private sector can stay liquid despite the burden of interest.

And this is exactly what we see in reality. The richest countries in the world have accumulated huge debts but still get more and more loans from the banks at much lower interest rates then the private sector in these countries. Without these economic stimulus packages from government debt more and more people in the private sector would go bust, banks would have to write off their claims against them and the money supply would decrease very fast. Profiteers of this are governments, who can lend out much more money than they could, if banks were not allowed to create it out of thin air, banks, who get interest for a product that they can create without any effort and that is demanded by everybody because the government collects its taxes denominated in units of it, and those who work for the government and get the fresh money first. This works as long as the interest the government has to pay for its credits is lower than the interest rate for the private sector.

Does a credit based fiat money system necessarily lead to hyperinflation because of the exponential function of interest on interest? Not as long as governments pay back at least the interest and banks, as we see it today, permanently decrease the interest rate for new government debts. The hyperinflationary scenario of the Weimar Republic was caused by the demand of the German government for foreign currencies to pay off reparation obligations according to the Treaty of Versailles. They had to print Papiermarks in a higher and higher quantity to acquire foreign currency on the forex market. But whenever a government doesn’t need too much of a foreign currency hyperinflation is not a necessary outcome of fiat money. What is necessary, however, is a permanent decrease in the purchasing power of the currency unit due to an ever increasing public deficit that causes an expansion of the money supply in the economy. People have to look for another long term store of value, but the currency can still be used as a medium of exchange and unit of account. This permanent decrease of the value of money must be linear at least and can be exponential under certain circumstances.

The reason for the exponential growth of the money supply and the national debt in the US, Japan or the Eurozone is not compound interest. In fact, interest rates for government bonds of the rich countries decreased dramatically over the last decades. And in addition to that they always paid the interest. No chance for a compound interest effect to occur! Money supply has been increasing exponentially rather because the economic stimulus packages only have an effect on the economy, if more new money than people expect is flowing into the economy. So long as money supply grows in a degree expected by the economic actors, they won’t change their investment behavior which already is adapted to their expectations. Only when there is more money flooding the market than expected will people change their investment behavior, raise credits, found companies and create jobs to earn some of the unexpected new money supply. And one thing is for sure: Trying to exceed the expectations of economic actors in relation to the future money supply again and again to provide effective economic stimulus will lead to hyperinflation in the end.


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