How inflation distorts the economy
Even beyond shattering the hopes and dreams of young children craving milk’s favourite cookie, the situation is worse than most people realise, because there is a little-known ramification.
Inflation not only hurts, it diverts. It economically harms the many by redistributing their wealth to a few.
The True Meaning of Inflation
To understand how, we must first get clear on what inflation really is.
Henry Hazlitt once said, “Inflation, always and everywhere, is primarily caused by an increase in the supply of money and credit.” In fact, inflation is the increase in the supply of money and credit.”
At least that was the original definition. But inflation has been redefined as an increase in the general price levels of goods and services. However, using inflation to mean a rise in prices, Hazlitt argued, “is to deflect attention away from the real cause of inflation and the real cure for it.”
Intuitively, this makes sense. For instance, if there is a natural disaster that disrupts the production of Oreos (what economists call a “supply shock”), they become more expensive because there are fewer cookies available. Alternatively, if a new recipe that uses Oreos becomes wildly popular (a “demand shock”), the rise in demand for Oreos also makes them more expensive. But money was not devalued in either of these scenarios. Oreos just became more valuable. Thus supply or demand shocks are not changes in the prices of all goods, but are specific to the goods affected, and the rise in the price of those particular goods reflects the newfound scarcity or demand. So it doesn’t make sense to call that “inflation.”
True inflation is the devaluation of a currency that makes each dollar worth less. As Hazlitt explained:
“When the supply of money is increased, people have more money to offer for goods. If the supply of goods does not increase — or does not increase as much as the supply of money — then the prices of goods will go up. Each individual dollar becomes less valuable because there are more dollars.”
Progressives like Sen. Elizabeth Warren and Robert Reich blame inflation not on monetary expansion, but on corporate greed.
But this makes zero sense. As FEE’s Dan Sanchez argued, “blaming rising prices on profit-seeking is like blaming a plane crash on gravity.”
“Gravity is always pulling down on planes. To explain a plane crash, you have to explain what happened to the factors that had previously counteracted that downward pull. Why did gravity yank the plane down to earth when it did and not before?
Similarly, businesses are always seeking profit and are always ready to raise prices if that is what will maximize profits. To explain precipitous price hikes, you have to explain what happened to the factors that had previously put a lid on that upward price pressure. Why did profit-seeking propel prices skyward recently and not in 2019?”
“Greed” did not spike suddenly, but something else did. The last two years saw a massive increase in the money supply.
The Cantillon Effect
Now that we are clear on what inflation is, we can explore how inflation diverts as well as hurts.
When the state expands the credit and money supply, it redistributes purchasing power and causes the misallocation of resources in the market. In that redistribution, there are necessarily winners who are able to purchase more and losers who are able to purchase less. This is called the Cantillon effect, named after Richard Cantillon (1680-1734) who first observed that money creation has uneven effects in the market.
When the state prints and spends money or makes money available to lenders, the government and the early recipients of the new money benefit. But that gain necessarily comes at the expense of others, because the new money has not produced any additional real wealth. As Ludwig von Mises explained:
“When the increase of money proceeds by way of issue of currency notes or inconvertible bank-notes, at first only certain economic agents benefit and the additional quantity of money only spreads gradually through the whole community. If, for example, there is an issue of paper money in time of war, the new notes will first go into the pockets of the war contractors. […] In this case, as before, there are those who gain by inflation and those who lose by it. The sooner anybody is in a position to adjust his money income to its new value, the more favorable will the process be for him.” [emphasis added]
Wars provide a great example of the Cantillon effect, where newly injected money causes a rise in prices for war supplies (benefitting manufacturers such as Lockheed Martin), which redirects the allocation of resources from consumer goods to weapons of war. Every weapon bought through printed money represents a redirection of resources.
As has been demonstrated, when the government prints money to fund its projects, it is essentially leeching wealth from everyone else while also making its priorities take precedence, usurping the market democracy.
Yet, this great power to print money and place the state’s priorities ahead of others does not go unnoticed. Benjamin Blau found that banks that had lobbied for five years before the great recession were 36 percent more likely to receive emergency loans than banks who hadn’t lobbied.
More recently, BlackRock has been selected by the Fed to “run purchases of corporate bonds and commercial mortgages that are part of its [the Federal Reserve’s] response to the pandemic-led recession.” BlackRock is allowed to buy some of its own funds on behalf of the Fed, while also charging the Fed a management fee of $8 million per year.
The way money is created is of the utmost importance, for the original recipients of money benefit the most. Clearly, businesses have an incentive to be close to the money spigot to maximise their benefits and minimise their losses. The logical conclusion of this fact is that the Fed can never operate as a neutral party, disinterestedly optimising the market.
Now it is clear that inflation is not only the devaluation of money that causes the prices of goods like Oreos to rise. It also redirects resources with some winners and losers, and it allows the politicians’ priorities to take precedence over individuals within the market. It’s a dangerous tool that rewards the businesses that collude with the state at the expense of everyone else.
This is an abridged version of an article that was first published by the Foundation for Economic Education (FEE).