Why Inflation?

By Philip Brewer on 12 October 2011 1 comment
Photo: Renato Ganoza

We know how inflation happens—excess growth in the money supply. But why does inflation happen? (See also: Can a Little Inflation be Good?)

Most people have a misunderstanding of inflation, because certain recent inflations—those of the 1970s in Europe and the United States—were unusual.

The 1970s inflations were largely side-effects: Working to keep their economies running at full speed, central banks boosted the money supply on the theory that accepting a certain amount of inflation would allow the economy to run with a lower level of unemployment. That theory turned out to be false, but that's not the important point. What's important is that "side-effect" inflation is the exception.

Most inflation—going back over hundreds of years and dozens of countries—is deliberate inflation, inflation produced with a goal: to reduce debt burdens.

Most often, the goal is to reduce the burdens of government debt. (Makes sense—governments control the money supply, and they tend to run up a lot of debt.)

Sometimes the goal is to reduce the debt burdens of ordinary folks. This isn't as common, in particular because inflation tends to hurt those with money, and people with money tend to have influence over the government. But, especially in democracies, and especially when society ends up divided between the few (who are very rich) and the many (who are poor and often in debt), the many turn out to have enough influence to call for some inflation to lower debt burdens.

Inflation does work for this purpose, but it doesn't work very well.

First of all, inflation only reduces the burdens of debts that already exist (and then only debts at a fixed interest rate). That's great for a government with a big public debt, and it's okay for homeowners (if they have fixed-rate mortgages) and recent graduates (if they have student loans at fixed rates), but it actually sucks for anyone who needs to borrow money—because they're going to face very high interest rates.

Inflation also produces all sorts of distortions. It creates phantom profits (where much, all, or even more than all of the gain is just inflation)—not so bad, except that phantom profits are often taxed just like real ones. It causes suffering because many prices can go up daily, while incomes often go up only annually. It makes it hard to plan for the long term (because you don't know what prices will be tomorrow, let alone 10 years from now).

The fundamental problem with inflation is that it fools people—it obscures true values and that leads people to make bad decisions. They get a good raise, and think they're better off. They see growing sales, and think their business is growing. Only later—when they see that prices have gone up and that even with the extra money that's come in they're no better off than they were—do they realize that they'd been misled. And if they made commitments based on that misunderstanding of their real situation, they may be in real trouble.

Right at this moment, things rather hang in the balance. As I said, the pressure for inflation is always strongest when the money is in the hands of the few and the many are in debt. Especially in a democracy, that's a dangerous situation.

Inflation is terribly pernicious. It's a blunt instrument that does reduce the burdens of debt, but does so in a crude fashion, with winners and losers selected for no more reason that that they had already borrowed (rather than being about to borrow) and that they had borrowed at fixed rates. There are things you can do to reduce the harm that inflation will do on your household economy (check out my post How to Live with Inflation), but even better is to avoid inflation.

Perhaps knowing why inflation happens will help with that.

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Isn't one of the main drivers of inflation (besides the increase in money supply) the level of demand for products and services? In case the demand is low, for whatever reasons, prices will not increase and inflation will stay low, regardless if there is ample supply of money.

One of the assumed advantages of an inflation of 1% or 2% a year is that it drives consumption and economic growth. If things are a little more expensive next year, why wait if you have the money and can buy it now?

Low, but slightly positive inflation is no problem and good for the economy. High inflation is a disaster for anybody who is a good saver and only beneficial for those with too much debts.