Leaving aside the events that made the current monetary system possible, banknotes that are printed monopolistically (currency) by central banks have purchasing power and serve as a general medium of exchange (money) for billions of people around the world. Such currencies (paper money), with no backing and with no non-monetary use, make up the monetary base upon which the fractional reserve banking system relies; first, through their privileged backing by central banks as lenders of last resort and second, through the reserve multiplier, allowing commercial banks to provide loans (bank money) beyond their reserves.
The new funds created and lent by commercial banks via mere accounting entries perform the same function as money and therefore increase the money supply. Given that increasing either the supply of bank money or that of paper money are the only two ways to increase the money supply, inflation is defined here as an increase in the money supply through either of these two forms of money. This inflation is external to the market process, and the redistribution it causes runs counter to the income and wealth structure that its absence would have given.
When new amounts of money enter the economy at different points, the prices of the goods (and services) involved are directly affected. Accordingly, prices never change all at the same time and to the same extent. But due to artificially stimulated demand, prices in general eventually rise. In this way, inflation triggers an exchange of nothing for something, which distorts the structure of prices and production. This leads to a decrease in the purchasing power of the monetary unit compared to what it would be without inflation.
The beneficiaries of such new money are always its first recipients. While prices have not been affected yet, the first recipients can redistribute a greater share of wealth in their favor. Meanwhile, those who receive the new money last, or not at all, are ultimately the most harmed by the price increases. Understandably, when people’s money loses value for reasons outside their control, their recurring desire to obtain more money has much to do with the imposed need to cope with the loss of purchasing power caused by inflation. All in all, since it is subject to supply and demand like everything else exchanged in the market, money is not neutral. And inflation by the system has negative repercussions not only on the value of money, but also on the process of wealth creation.
Today, the term “inflation” refers, in common parlance, to the general increase in prices and, more specifically, to what is conveyed by the price inflation figures published by governments. These figures, such as the Consumer Price Index (CPI), are calculated based on a specific, limited selection of goods, with the assumption that an average price for goods can be established. But this is impossible, as it involves adding or multiplying quantities of different goods that are valued differently (subjectively). Additionally, the case of so-called “real terms” is no better, as it purports to present an accurate comparison of purchasing power over time using the already flawed CPI.
What’s more, the conventional understanding of the word “inflation,” coupled with a lack of understanding of real inflation, leads to the typical confusion between a general increase in prices and price changes that have causes other than real inflation. Come what may, prices and people’s valuations can change and, in fact, often do change for reasons unrelated to any increases in the money supply. That is, prices fluctuate for infinite reasons. Overall, no one can really know how many additional monetary units are needed to equate the purchasing power of a certain amount of money in the past, since no one can measure a universal and objective purchasing power of any monetary unit at any given time.
In addition, the commonly adopted definition for hyperinflation is a monthly price inflation rate of 50%. However, this numerical definition is also arbitrary and based on misconceptions. And, in general, little attention is paid to the prior process of money printing, which is directly related to the significant decline in demand from the population for their government’s currency. It is precisely in this context that the phenomenon of hyperinflation normally originates. Inflation cannot last forever, but has a limit in terms of both time and tolerance among the population, beyond which hyperinflation sets in. This destroys the currency on which the population depends for its economic decisions, as its value rapidly tends toward zero.
On the other hand, government officials, as well as their intellectual courtiers in academia, often claim that the system, i.e., the central bank and commercial banks, must satisfy the population’s increasing demand for money. But in reality, this increase can be satisfied without inflation when people accept lower prices to trade and achieve the cash balances they desire—similar to how, on the contrary, they would spend more money on the goods they demand more of. In short, any quantity of money in the economy is enough to ensure everything that money can do for the population, which disproves any logical need for the continual inflation by the system. Demand for money does not imply more money, but a higher price for money.
Since money as such does not need to be produced in response to any increase in demand from the population for enabling an increase in social wealth, governments are inevitably unable to know when and how much to increase their money production to match the demand. The only thing that governments can know is when and by how much to increase their money production to satisfy their own demand for money and thus fulfill the commitments they discretionarily took. In this process, a government forces other members of society to finance wealth redistribution through the loss of their own purchasing power. Hence, government inflation is both arbitrary and coercive.
In the analysis, the cost of producing paper money for governments is completely irrelevant. If more and more people were allowed to obtain money at no cost, their need to produce or sell anything that others value would end up vanishing. The monetary unit would lose value quicker and quicker, and fewer and fewer goods would be produced, increasingly impoverishing society as a whole. Increases in the money supply of this kind redistribute existing wealth without enriching society and run counter to the very incentives for wealth creation. Because as soon as the acquisition of money increasingly ceases to come from exchange, the production of goods for exchange or for one’s consumption is discouraged. This adds to the reasons why the current system works against wealth creation.
By contrast, take the example of gold as money in a market economy without government intervention. Miners incur real costs to extract gold as a raw material with the aim of generating income, and they may fail and lose money in this enterprise. Any amount of new gold allocated for monetary use will increase the money supply. But this increase is the result of a productive endeavor that will be coordinated with the production of other goods offered in the market according to the law of supply and demand. Here, any increase in the money supply is internal to the market and implies the exchange of something for something.
Returning to the present world, since the injection of new money into the economy never reaches everyone equally, there are people who benefit from it, both inside and outside the government. The injection may come from the expansion of credit through the fractional reserve banking system under the direction of the central bank. Likewise, new money may also come from the monetization of the government deficit, whether fiscal (budgetary) or financial (extra-budgetary). In fact, the money created to finance extra-budgetary activities, such as in the government securities market and the central bank’s open market operations, also forms part of total government spending and affects the monetary base and, therefore, the money supply. Moreover, the current monetary system is often responsible for enormous redistributions of wealth that enrich very few people, which take place at the highest levels of politics and the financial and commercial establishment. This further reveals the perversity of keeping ordinary citizens sufficiently calm with “moderate” levels of general price increases, while those at the top enrich themselves at the expense of the former.
Understanding how and why prices are constantly rising in today’s world is essential if we want our governments to stop abusing us monetarily. In this sense, losing sight of what is really happening behind the constant increases only helps governments to continue with an inflationary system that, on top of everything else, makes it difficult for most people to save.
Certainly, regions that separate from their current governments could probably adopt anything but the inflationary currency of their former governments. Nonetheless, for that matter, to end the injustice and impoverishment caused by current inflation anywhere, all government intervention in the monetary sphere must be abolished, and with it, all fractional reserve banking. The solution could be a reform that removes all intervention at once, leaving its results to the market process. As the monopoly on money production would end, people would be faced with different alternatives. Existing currencies with a fixed supply could continue to be used until people find other, more convenient alternatives. Old monies such as gold could also return. Free and competing monetary institutions could develop. In any event, something is clearly predictable: having realized the evils of the present monetary system, at least for a generation, people would not try any innovation that resembles the creation of money out of thin air.
A world free from off-market redistribution through inflation, from credit expansion-induced business cycles, and from other systemic harms is not impossible. Yet, for reforms like these to gain traction, even if the term “inflation” is lost in public opinion, it is crucial that most people understand the workings and effects of increasing the money supply by the current system.
