HAWAII, May 2, 2012 – Earlier this week, Republican presidential candidate Ron Paul debated economist Paul Krugman on Bloomberg TV and delivered a powerful statement on the nature of our government’s monetary policy:
“Inflation is theft, you’re stealing value from people who save money. So if you have a two percent or ten percent, the value of the currency is lost. And it really destroys an important feature of the economy, and that is savings.”
Unfortunately, the implications of Paul’s warning that “inflation is theft” probably went over the heads of the majority of people who watched the debate. From Capitol Hill to Ivy League university student centers to the streets of almost any city, when asked “What is inflation?” most people will respond “a rise in prices.”
Prices are the exchange ratio between money and a unit of goods. The problem with just defining inflation as a general increase in the level of prices is that it does not take into consideration the effects of demand.
In a hypothetical fixed money supply where the total amount of currency never changes, more money chasing one good means less money available to another. Rising prices for one good in response to higher demand should result in falling prices for another good of lesser demand.
If Jack, John and Justin are men shipwrecked on a small desert island and have selected rusty soda bottlecaps as their market currency and there are only 30 caps on the island, increasing demand for Justin’s stone hammers means less caps available to purchase John’s fish hooks and Jack’s palm baskets, thus prices for hooks and baskets should fall.
Under these circumstances, it is impossible that a general increase in prices for all goods on the island can occur without actually adding more bottlecaps. Inflation therefore is more appropriately defined not as an increase in prices but an increase in the money stock.
How inflation ruins an economy and encourages bad decisions
In the case of the U.S. Government, the Federal Reserve is able to artificially expand or contract the total supply of dollars through the control of interest rates. Unlike the desert island where price is moderated by scarcity of currency, no such limits exist for the dollar.
As credit increases, market demand curves increase and higher demand creates higher prices. The evil of a continual credit expansion is that, as Paul suggests, those who receive the credit and spend it benefit at the expense of those who save their money, right up to the inevitable crash of the economy.
Because raising taxes to pay for spending is extremely unpopular, a frequent tool of government is to borrow against the future to finance today’s pet projects. Whenever our government “invests” in things – say for example, $295 billion in infrastructure spending under ARA – the recipients of the funding spend the money first, causing prices to rise across the market as demand curves increase for everyone who gets the new money. But those who receive the money last or not at all discover a market where prices have increased but their money in the bank remains the same.
In this regard, both government spending and government control of credit is a terrible inflationary force. Rather than helping the elderly and the poor with fixed or small incomes, government’s inflationary interventions in the marketplace punish them with a hidden drain on their money.
On the opposite end of the spectrum, inflation favors reckless spendthrifts and irresponsible, insolvent corporations who spend now and exploit cheap cash from the central bank. As Thomas Paine warned in a 1786 pamphlet:
“There are a set of men who go about making purchases on credit, and buying estates they have not wherewithal to pay for; and having done this, their next step is to fill the newspapers with paragraphs of the scarcity of money and the necessity of a paper emission, then to have a legal tender under the pretense of supporting its credit, and when out, to depreciate it as fast as they can, get a deal of it for little price, and cheat their creditors; and this is the concise history of paper money schemes.”
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