Chapter 22: The Mirage of Inflation
Thy silver is become dross, thy wine mixed with water (Isaiah 1:22).
The prophet Isaiah was publicly criticizing the nation as a whole. He also spelled out the crimes of political rulers. They were bribe-takers. They were companions of thieves (v. 23). They rendered false judgment, cheating widows and orphans (v. 24). But before these crimes, he mentioned monetary debasement: cheap metals mixed in with silver. The word "debase" comes from "base" metals -- cheap metals. This was monetary inflation.
Isaiah was making a point. The sins of the nation had debased the nation. The corrupt practice of silver smelters was to mix low-cost metals into the molten silver. This produced bars that looked like pure silver, but were not. This was counterfeit metal. It was deceptive. People in Israel initially thought that the silver bars had high value because of silver's scarcity, so the smelters continued to deceive the public. More counterfeit silver bars had come into circulation than there would otherwise have been, had smelters not debased the bars.
Isaiah did not say that prices had risen. But his listeners knew. And it was not just the smelters who were doing this. The wine makers were, too. There was larceny in their hearts.
He warned of a coming judgment by God. He used the language of smelting.
Therefore saith the Lord, the LORD of hosts, the mighty One of Israel, Ah, I will ease me of mine adversaries, and avenge me of mine enemies: And I will turn my hand upon thee, and purely purge away thy dross, and take away all thy tin: And I will restore thy judges as at the first, and thy counsellers as at the beginning: afterward thou shalt be called, The city of righteousness, the faithful city (vv. 24-26).
The society was ethically corrupt. The society was ethically counterfeit. But the purging would be real.
The debasement of Isaiah's day was kids' stuff compared to today. That was because of the limits of deception. Pour too much dross into the molten metal, and it will no longer look like silver. The modern world has debased its coinage. No nation's mint issues silver coins as common coinage -- only as collectibles. By the mid-1960's, silver coins were replaced by counterfeits.
In 1965, most money was not coinage, as is true today. Most money was a combination of paper currency and bank checks. Printed currency of any denomination all looked alike. The "dross" was paper and ink, worth a few cents. The "silver" was the face value of the bill. The central bank's profit -- mark-up -- on printing these bills was enormous. The governments had laws against printing counterfeit bills, but their central banks printed nothing but counterfeit bills. What held this process in check was the threat that people could bring in their paper money or write checks and get gold coins. That ended in Europe in late 1914: World War I. It ended in the United States in 1933. It ended for silver coins in the United States in 1964. (Note: in the summer of 1963, I converted almost all of my money into silver coins, which I got at a bank at face value. By the end of the summer, these coins started going out of circulation as a result of Gresham's famous law: "Bad money drives good money out of circulation.")
Today, most money is digital. All digital money is counterfeit money. We do not even see the money any longer. We use pieces of plastic. Computers communicate with each other.
Counterfeit money is morally wrong. It is a form of theft. But economists do not like to invoke ethics in their analysis of economic cause and effect. They also do not like to criticize theft by civil governments as theft, for that brings up this ethical issue: "Thou shalt not steal" (Exodus 20:15). It does not say, "Thou shalt not steal, except by majority vote."
Hazlitt followed the lead of Ludwig von Mises. He used the word "inflation" to refer to fiat money creation. He did not use it to describe the result of fiat money creation: rising prices. Isaiah preceded both of them in this regard. He identified the evil of inflating -- and it is evil. Mises did not mention ethics and economics together. Neither did Hazlitt. Murray Rothbard did. He always labeled inflating as theft.
The best definition of money, analytically speaking, is this: the most marketable commodity. Throughout history, this has meant gold and silver. Before the sixth century, B.C., in Asia Minor this meant bars. After, it meant coins.
There are owners of non-monetary assets. There are owners of monetary assets. Why does anyone hold money? Because money is used to make purchases. It is a medium of exchange. It is owned only because the owners expect others to exchange non-monetary assets for money. Money has a wide market. It has an instant market. You don't have to argue with a seller to accept your money at the retail price for whatever he is selling. You don't need to take a discount for cash. You may even get a discount for cash.
When we are talking about a scarce resource, more is better . . . at the same price or lower. If an individual gains more, he is better off. This is also true of groups. When there is more to be had because the supply has risen, this is good for everyone.
With respect to money, more is also better, but only for individuals. When people inside a monetary union all gain more money because the supply has risen, they are not better off. This makes money unique. When one person gives another person some money, the recipient is better off than before. The person giving money may be better off, too. "It is more blessed to give than to receive" (Acts 20:35). But he is worse off monetarily. If the central bank were to create new money, and then give it away by crediting everyone's bank account with more money, this would not make society richer.
Why the difference? Because money is desirable in exchange, but not for personal consumption. In Robinson Crusoe, Crusoe is on the half-sunken empty ship that carried him to the island. He loads up with all of the ship's supplies that he can carry. He then comes across the captain's money box. He takes some coins, but only after he has loaded up a raft full of useful tools. The coins will be valuable if a ship ever comes and rescues him, but not otherwise. If he is not taken back into society, the coins are useless except as decorations.
Think of a counterfeiter. He prints new money. He spends it on items he wants. He is better off after these trades. So is the person with the fake money, as long as he never figures out that it is fake, and as long as no one else finds out. But society is not better off. It is worse off. A counterfeiter is on the loose.
The government does not worry about a lone counterfeiter. It worries about imitators. One counterfeiter who spends money only on lunches and car repairs is not a threat. But he must be prosecuted as a warning to potential rivals.
The counterfeiter's biggest rival is the national government's central bank. Actually, the counterfeiter is copying the central bank. The central bankers resent this as an invasion of the bank's turf. They call on the government to track this criminal down and arrest him. In the United States, the agency in charge of tracking down counterfeiters is the Secret Service, which also defends the life of the President.
If an inventor makes a health-improving discovery, and he puts it into the creative commons on the Internet for free, lots of people will soon be better off. In contrast, if a counterfeiter finds a way to produce untraceable counterfeit bills on a cheap 3-D printer, and then he releases this information on the Internet, society will soon be worse off. People will steadily lose faith in the currency. This will reduce its purchasing power, i.e., raise prices. This undermines the value of all currency bills, which are valued only for expected future exchanges. So, if the supply of a resource increases, its price will fall. This is an advantage to consumers. In contrast, if the money supply increases, its value will fall. This is a disadvantage to consumers. They cannot easily find a replacement currency that other people will sell goods in order to obtain.
If the future value of money is widely expected to be about the same as the past value of money, this maintains the value of money. Any unexpected increase in the money supply upsets people's expectations about the future value of money. The cost of holding money therefore increases because of this increased risk: holding depreciating money.
The stone is thrown by a government-licensed bank or bank cartel that has the authority to create money out of nothing -- these days, by computer entry. This process is initiated by the nation's central bank. It can also be done by a commercial bank that operates under the authority of the central bank. Because the government licenses and protects the banking system from bank runs, the banks create money. They lend it into circulation, and charge interest to the borrowers. It is profitable to counterfeit money.
Central banks prior to 2008 usually bought only debt certificates (IOU's) issued by major governments. Since 2008, there is evidence that some central banks also buy stocks or stock-related assets. They surely buy the debts once held by banks that are facing bankruptcy.
The banks purchase IOU's. The borrowers then spend this money to buy whatever it is that they buy. Those sellers who receive this money then deposit it in their banks. This spreads digital money through society.
This new money does not create wealth. It redistributes wealth. Those sellers who get access early to the newly created legal counterfeit money go out and buy things at yesterday's prices. The new demand from the new money has not yet registered on sellers of goods and services. So, with more money to spend, these newcomers with their freshly created counterfeit money start buying. This takes goods and services off the market. Other potential buyers cannot locate these goods and services, because someone else got there first.
We know that a free market economy is a giant auction. The auction has one rule: high bid wins. What if you went to an auction to bid on items. You notice that there is a man in the back of the room with buckets full of paper money. He keeps talking with people in the back of the room. They sign a piece of paper, and the man with the buckets hands over a bucket. You notice that the bids of the people in the back of the room are higher than the bids of people at the front of the room.
The auctioneer is delighted. You are not delighted. You cannot compete with the people in the back of the room. You are going to go home with the same amount of money, but no bargain items. Next week, you will have made a deal in advance with the guy with the buckets full of money. You will sign the pieces of paper -- IOU's -- in order to get your hands on a bucket of money.
Others will do the same. Pretty soon, the prices at the auction are higher than they were two months ago. There are no more items to buy, but prices are higher.
The winners are the people who started going into debt at the first auction, when prices were lower. They took home the wealth at bargain prices. There has been no creation of new wealth. There has only been a redistribution of existing wealth.
The auction model works for considering costs. First, the people who did not figure out how the new system works are losers. They would have taken home more goods from the auction, had the man with the buckets of money not shown up.
Second, everyone who attends the auction has greater debt. Everyone had to sign a series of IOU's in order to get a continuing supply of newly created counterfeit money.
Third, prices are higher.
Fourth, if the supply of counterfeit money stops, everyone who took on added debt will be in trouble. Prices at the auction will not go higher, but the bidders will find that they must now bid lower for items. Why? Because part of their ordinary income must now be used to pay off the pile of debts. They cannot go to the auction with as much money as they used to.
Fifth, prices at the auction now revert back to where they were before the man with the buckets of money showed up. This means that the bidders who paid high prices at recent auctions find that the value of these items is falling. They looked like good deals when the bids at the auction were rising, but now the bids are falling. So, bidders will bid less at the next auction. They are burdened with debt, and now prices are falling. They will fear to bid high prices.
Here, we can see what happens to an economy that is manipulated by central banks and commercial banks. When the banking system started creating fiat (legal counterfeit) money, the new money created the illusion of new wealth. Those who spent their newly created money early won. This was the boom phase of the economy. But now the economy is in the bust phase: a recession. Demand has fallen. Debt has risen. Consumers reduce their spending. The auctioneers of the world now find that demand is lower. Their profits are lower. But they had expanded in the boom phase. They borrowed money to hold more auctions.
A real auction deals with used goods. In the overall economy, the auction is for new goods. The boom persuades businesses to borrow, buy raw materials, rent buildings, and increase production. Then, without warning, demand falls. These businesses are now unprofitable. Their markets are shrinking. Buyers are holding back. Now businesses start going bankrupt. The auctioneer arrives to pick up inventory. This new supply leads to lower prices at the auction. The recession may turn into a depression. It did in the decade 1930-1939, all over the world.
The price signals during the boom phase misled investors, producers, and consumers. These people made mistakes. They took on too much debt. Now the day of reckoning -- the day of accounting -- has arrived. Profits turn into losses.
How does Bastiat's analysis apply here? What is the thing not seen? This: the array of prices that, apart from legalized counterfeiting, would have been produced by the auction's rule of high bid wins. We see the booming auction and mini-auctions all around us. We do not see the world that would have prevailed without legalized counterfeiting. As Hazlitt put it, inflation produces a mirage. Thirsty people, lost in a desert, walk toward the mirage: a hoped-for oasis of life. It is not there. It is an illusion. At some point, the thirsty wanderers will realize this. But they will be far from an oasis. They will be far deeper into the desert than they would have been, had the banking system not produced a seemingly endless series of mirages.
When the West went off the gold coin standard late in 1914, as a result of the early phase of wartime financing, the depositors lost their gold. They had been promised for a century that if they deposited gold coins at a bank, they would be paid interest, and they could get their coins back at a fixed price. That was a massive deception. Then, late in 1914, the central banks and governments of Europe reneged on the promise. They stole the gold. Then they issued fiat money. Except for Great Britain, 1925-1931, no European nation ever again restored a gold coin standard. President Roosevelt in the spring of 1933 did the same thing. He was even worse. Not only would the banks not honor their promises to redeem (sell back) gold at $20 an ounce, he declared it illegal for Americans to own gold. He declared this on his own authority. Congress later passed a law validating Roosevelt's unilateral declaration.
From 1934 until August 15, 1971, central banks and governments could buy gold from the United States at $35 an ounce. Following Roosevelt's precedent, President Nixon on a Sunday evening unilaterally announced that the United States would no longer honor its pledge to redeem gold to foreign central banks and governments. He "closed the gold window," just as a handful of economists, including me, had for several years predicted he would. The Federal Reserve began creating fiat money on a massive scale to get the nation out of a recession. The result was rising prices. Prices rose from 1971 to 1981 at a more rapid rate than at any time in the history of the United States in peacetime. There were a series of recessions: 1975, 1980, 1981-82. From 1971 until 2016, consumer prices rose by almost six-fold. (http://bit.ly/BLScalc)
All over the world, central banks followed the lead of the United States. They inflated. The result was rising prices in every nation. Debt also rose: government, corporate, and personal. A level of debt now exists that has not existed since 1946, when Hazlitt wrote his book. That debt was abnormal: the product of World War II. Today's debt levels have become normal. Politicians, corporate CEO's, and households are used to these debts. But if central banks cease inflating, these debts will be revealed as unsustainable. At that point, there will be debt liquidation and bankruptcies. Central bankers fear this, and so they return to inflating. This continues the bad investing that prevailed in the previous boom phases.
In 1972, a collection of articles by F. A. Hayek was published in Great Britain: A Tiger by the Tail. It was on central bank inflation. The tiger today is much larger. It is much more dangerous. The world is still on the tiger's back.
Money is the most marketable commodity. It is the central economic institution. It is the result of the division of labor, and it has become central to the division of labor. It is the source of price signals. The price system is the greatest source of information in history. But central banks and commercial banks now manipulate this price signal system by their policies of legalized counterfeiting. They have done so aggressively ever since late 1914 in Europe and ever since 1933 and then 1971 in the United States. They have placed the world on a fearful tiger. That tiger is fed by fiat money. It gets ever more ravenous.
The greatest threat economically today is a debt implosion. The level of worldwide debt is greater than ever before. It is unprecedented. It can only be sustained by new rounds of monetary inflation.
The previous periods of monetary inflation, all over the world, have extended the division of labor. The price signals have been manipulated by the banking industry. These signals are as counterfeit as the money. If the banking system ever ceases to inflate, bankruptcies will multiply. Today's division of labor has been artificially extended by false price signals. We are in an international auction that is dependent on new rounds of fiat money, with the men in the back of the room lending out buckets of digital money.
We call a mild contraction of the division of labor a recession. A major contraction is called a depression. The world has not seen a depression since 1940. People are not mentally, emotionally, or financially prepared for another depression. This is why central banks continue to inflate. But the end of this policy is hyperinflation. That, too, contracts the division of labor.
When the division of labor contracts, most people get poorer.
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