Inflation v Deflation – State Finances


by Alasdair Macleod, GoldMoney:

There is a general belief, and that is all it is, that state finances fare better in an inflationary environment than a deflationary one. This perception arises from the transfer of wealth from lenders to the state through a devaluation of the currency, which occurs with monetary inflation, compared with the transfer of wealth from the state to its creditors through deflation. The effect is undoubtedly true, even though it is played down by governments, but it ignores what happens to continuing government obligations and finances.

This article looks at this aspect of government finances in the longer term, first on the route to eventual currency collapse which governments create for themselves by ensuring a continuing devaluation of their currencies, and then in a sound money environment with a positive outcome, for which there is good precedent. This is the second article exposing the fallacies of supposed advantages of inflation over deflation, the first being posted here.

Inflationary policies

While central bankers have convinced themselves, in defiance of normal human behaviour, that consumption is only stimulated by the prospect of higher prices, there can be little doubt that the unmentioned sub-text is the supposed benefits to borrowers in industry and for government itself. Furthermore, the purpose of gaining control over interest rates from free markets is to reduce the general level of interest rates paid to lenders, further robbing them of the benefits of making their capital available to willing borrowers.

All this is in defiance of the principles behind contract law, but the courts do not accept that the unbacked state-issued currency of today is no different from the gold-backed money of yesteryear, nor the same as tomorrow’s further debased currency. Tax on interest is an added distortion, reducing net interest received by holders of depreciating currency even more. It is hardly surprising that the savings rate collapses in an economy characterised by inflation and taxed savings, leading to a relentless expansion of debt, financed by other means.

These “other means” are mostly the expansion of bank credit, which is money created simply through book-entry. The cost of creating this money is set by the wholesale money rates, which are in turn set by the banks that issue the credit. If they all expand their bank credit at the same time (and it should be noted that bankers are very susceptible to herd instincts), interest rates can theoretically fall to zero, or more practically, the marginal cost of expanding it, which on large loans is almost the same thing. And as if that is not enough, there is now in addition a combination of central banks rigging interest rates to be negative coupled with quantitative easing, which has even allowed corporate borrowers to be paid to borrow money.

 As already stated, the whole point of monetary inflation is to transfer wealth from lender to borrower. In the government’s case, it is a replacement for taxes that have become so burdensome, that to increase them further either risks provoking a taxpayers’ rebellion, or is so economically damaging that even the state knows to back off. But the books must be balanced, and given the unpalatable alternative of cutting spending, funding through monetary debasement is the accepted solution.

Most central banks understand from experience that if the central bank is involved in funding the government’s spending directly, the currency will eventually descend into crisis. Instead, central banks achieve the same thing by suppressing interest rates and allowing the commercial banks to subscribe for government bonds. They are bought by the banks themselves, or alternatively by lending to others to buy the government’s debt. There are technical monetary differences between bank and public subscriptions for government debt, which must be conceded. Nevertheless, it is just as inflationary, being supported directly or indirectly by the expansion of bank credit, particularly when central banks ensure that total currency in circulation will never be allowed to contract.

An important assumption behind long-term inflation targets, currently set at 2% per annum, is that the general price level can be controlled by managing the money stock. This flies in the face of all experience, and even economic theory. During the Volcker chairmanship of the Fed, when the effective Fed funds rate rose to over 19%, there was no let-up in the growth of broad money. It grew at 6.2% that year, compared with a long-term average annual growth rate of about 5.9%.[i] To link interest rates to the money-quantity is a common mistake by those who do not realise that interest rates regulate not the quantity of money, but its application.

The rate of US monetary expansion was reasonably constant at a little less than 6% until the Lehman crisis, yet interest rates (measured by the effective Fed funds rate) had varied between 19.1% in 1981 and 1% in 2003. US consumer price inflation had also varied between 14.4% and 1.07% on the same time-scale. There is no correlation between the quantity of money and these two statistics at all, so the control mechanisms employed, which are meant to regulate the decline in the currency’s purchasing power, are entirely bogus.

The point was sort of accepted by an official at the Bank of England last week. Richard Sharp, who is on the Bank’s financial stability committee, warned that if the UK Government increased its borrowing, it risked sliding into a Venezuela-style crisis. Undoubtedly, this comment was provoked by a growing debate over Jeremy Corbin’s proposal to borrow an extra £250bn if Labour is elected. But it raises the question over what is the difference between Venezuela’s disastrous inflation policies and those of Britain, other than scale. The answer is simply nothing.

Venezuela’s economic collapse into hyperinflation is all our final destinations as well. It is the eventual destination for all governments that depend on financing themselves by inflation. No longer are deficits being talked about as only temporary. Realistically, the accumulation of welfare liabilities, past, current and future, make it impossible to balance the books from taxation alone.

The fallacy that the state benefits from inflation ignores our central point: it transfers wealth from the masses. Far from stimulating the economy by persuading the masses to spend rather than save, it gradually grinds them down into poverty. The high standards of living in the advanced economies were acquired over decades by ordinary people working to improve their lives. The accumulation of personal wealth is vital for the enjoyment of improved standards of living. Remove earnings and wealth through currency debasement, and people are simply poorer. And if people are poorer, the finances of the state also become unsustainable.

This is why regimes that exploit the expansion of money to the maximum, such as Venezuela and Zimbabwe, demonstrably impoverish their people. It takes little intellect to work this out, yet amazingly, neo-Keynesian economists fail to grasp the point. The most appalling example was Joseph Stiglitz, a Nobel prize-winner no less, who ten years ago praised the economic policies of Hugo Chavez.[ii] Ten years on, we know the result of Chavez’s inflationary follies, which have taken Venezuela and her people into the economic abyss. Despite Stiglitz’s execrable errors, he remains an economist respected by those whose biased analyses are simply to wish reality away.

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