Recently, I was reading an article in the Economist about the potential danger of imminent inflation in the USA. And it occurred to me that, for most people, inflation (the general rise in prices) is just something that happens. It’s something that trade unions dislike, and politicians worry about. It also has something to do with the Reserve Bank and interest rates. But it’s a bad thing.

And it can be a very bad thing indeed, because inflation can be used as a tool. In the past, inflation has been used to keep countries in a state of civil collapse. The worst inflation on record (in Hungary after World War II) was forced upon the Hungarian people by the Soviets (at least, according to a number of economic scholars). Lenin talked about debasing the currency as being the easiest way to overthrow a regime. And the worst part is that inflation inevitably runs out of control, once people start to expect it. The real question: how is inflation generated to those levels that it brings a country to a state of collapse?

If we’re going to ask that question, we should probably back-track and ask “What causes inflation?” Any good economics student should tell you that it happens in one of two ways:

  1. Manufacturers have to spend more to produce their goods (say, for example, the oil price goes up – well that increases the cost of manufacturing and distribution across the board); or
  2. People want to buy more goods (ie. they wish to spend more).

Generally, inflation-targeting Reserve Banks try to control the second one (they can hardly influence the oil price), and they attempt to do so with interest rates – incentivising people to save with higher interest rates (thereby lowering their demand, and slowing the price rise), or incentivising people to borrow with lower interest rates (thereby increasing investment and economic growth).

A crucial assumption underlies this process: a consistent and predictable money supply. And that makes sense, because generally, only Reserve Banks are able to print money (they are the “Monetary Authorities”) – and they are reasonably independent of the “Fiscal Authorities” (being the government).

Two key definitions then:

  1. Monetary Policy: refers to the Reserve Bank’s decisions around interest rates (they have the power to set a base interest rate), money supply (they have the power to print money) and exchange rates (they are the central repository of foreign reserves – or money denominated in foreign currency).
  2. Fiscal Policy: refers to the Government’s decisions around the Budget. That is, what they are going to spend money on, and where they are going to get the money to finance their spending.

What does this have to do with tax?

The “Fiscal Authorities” (the government) safeguard the public good: spending money on defence and national health and schooling and so on. But all this spending needs to be financed somehow – just as I need a job in order to pay my rent. Governments have some choices:

  1. Collect taxes (the equivalent of earning a salary – that is, being paid by the public for the service it provides)
  2. Borrow (obviously – the equivalent of taking out a loan or buying on credit)
  3. Print money (or, more accurately, get the Reserve Bank to print the money)

For number 3, there is no real individual equivalent – I do not have the option of creating money out of nothing. But the monetary authorities are the virtual orchard of money-producing trees. And when the fiscal authorities can’t collect taxes properly, or collect enough taxes, and they’ve run up their debt to the point where they can’t borrow any more, compelling the monetary authorities to “create” money begins to look like an attractive option.

And what happens when you suddenly start creating money? Well, the government spending ripples the new money into the rest of the economy, and more money means that people want to spend more. You have people with the ability to buy more, without a change in what’s available to buy. So it’s a seller’s market, and they put up their prices: inflation.

Which indirectly begins to work like a tax. If you have money in the bank – you may have the same physical amount; but in real terms, you can’t buy what you used to. Effectively, your spending power is confiscated and used to fund government spending. Now that’s quite handy – rather than having collection agencies, the government can just suspend the independence of the Reserve Bank, and tax everyone immediately by pressing “print” on the presses.

And contrary to popular belief, we’re not talking about coins and notes. No – the majority of money creation (these days) is electronic. In effect, you delete the old account balance in the bank records, and type in a new one – only limited by the number of zeros you can type.

Right now, it’s all sounding very efficient. Sod a collection agency. But if you take the process a couple of steps further, what generally happens is:

  1. Because people are people, we like to pay as little tax as possible.
  2. And because inflation only affects cash, people attempt to hold as little cash as possible, investing in “real assets” (property, cars, shares on the stock exchange, foreign currency, non-perishables/commodities, etc).
  3. Sellers, expecting inflation because of the current monetary policy, increase prices again to compensate for future inflation (in economic terms, this is referred to as “adaptive expectations”).
  4. Some take the tax avoidance a step further, realising that if they buy real assets with borrowed money, inflation will erode the real value of their debt – and they will, in effect, be taxing their lender.
  5. Generally, those in 4 are the wealthy – because they have physical property to stand collateral for their borrowings.
  6. The increased demand for real assets drives prices up further.
  7. The increased inflation drives up the adapted expectations of sellers, who push prices up still further.
  8. Inflation gains its own momentum, and begins to spiral out of control (it’s around this time that we start calling it hyperinflation).
  9. Civil collapse as everyone panics and no one wants to hold cash.

But the inflation has some interesting implications – particularly given the state of the First World today:

  1. As money loses its value, so does anything that has a fixed monetary value.
  2. Government Debt has a fixed monetary value.
  3. As time goes on, Government Debt is eroded.

To use an example: let’s say that the price of a loaf of bread is $1, and I have a loan from the bank of $10,000. Inflation drives the price of bread up to $100 (and this is not as drastic as it sounds – it was exponentially worse in the recent Zimbabwean Hyperinflation). Initially, I owed the bank 10,000 loaves of bread (in real terms). Post inflation, I owe them 100 loaves. Sure – I pay more for bread – but my salary would also have to increase in response to inflation while my debt remains unchanged.

So, in conclusion, who wins with inflation:

  1. The Government – its domestic borrowings are eroded, and it has an efficient taxation system to fund its spending.
  2. The Rich – who can borrow and hedge against inflation, as well as profit off it.
  3. Borrowers – whose debts are eroded by inflation
  4. Manufacturers – who have their largest investments in stock and machinery

And who loses:

  1. The Government – as actual taxes are paid in arrears, inflation erodes the real value of taxes. Eventually, the Government loses all sources of revenue other than money creation.
  2. The poor – who cannot borrow and therefore cannot hedge themselves against inflation.
  3. Pensioners – who collect fixed pensions, which are then eroded by inflation.
  4. Savers – whose bank balances are eroded by inflation.
  5. Wage-earners – because wage adjustments tend to lag behind inflation, like a dog chasing its tail.

Effectively, inflation becomes a tax on the poor, the working middle class, the elderly and the financially conservative.

And what drives this type of inflation? Money creation. Or, in journalistic terms, when Reserve Banks engage in quasi-fiscal activities and/or “quantitative easing”.

So when American Economists start to argue that a short burst of inflation might be good for their economy – it’s all a bit concerning.