Harmful effects of inflation

June 17th, 2008

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Lately, price inflation around the world looks to be getting out of hand (see A resemblance of the beginning of Weimar-style inflation). When price inflation was affecting asset prices, nobody complained because it conveys an illusion of prosperity. But when it spills over to the prices of daily living, it provokes a reaction of kicking and screaming among the masses. Indeed, 15 months ago, before the mainstream masses had any idea that the ravages of inflation will eventually hit them hard, we warned in Have we escaped from the dangers of inflation? that

… we are very sure that as all these liquidity work its way to the rest of the real economy, it will only be a matter of time before price inflation will show its ugly head. Yet we are simply amazed with Wall Street?s obliviousness to this danger and Ben Bernanke?s incredibly sugar-coated words in his recent economic report to Congress. Can we rely on the Chinese to forever keep the price of importable things down to save us from inflation?

Make no mistake about this: central banks around the world are still inflating the supply of money and credit. With such a colossal amount of debt in the global financial system, there is no other choice but to continue inflating in order to remain solvent. As inflation worsens, we will all pay the price for the harmful effects of inflation.

Today, we will look back into history and learn how inflation nearly destroyed a country. We will turn into an old book, The Economics Of Inflation- A Study Of Currency Depreciation In Post War Germany, written by Costantino Bresciani – Turroni, an economist who lived through the German Hyperinflation of the 1920s. In chapter 5 of that book, he wrote,

The inflation profoundly altered the distribution of social saving. It is true that at first a certain mass of “forced saving” was created. But it cannot be said that these savings became available to the most productive firms and to those entrepreneurs who were most able to employ rationally the capital at their disposal. On the contrary, inflation dispensed its favours blindly, and often the least meritorious enjoyed them. Firms socially less productive could continue to support themselves thanks to the profits derived from the inflation, although in normal conditions they would have been eliminated from the market, so that the productive energies which they employed could be turned to more useful objects.

Nowadays, the less socially productive businesses include investment banking, money shuffling (hedge funds) and home building (in the US). Inflation allow mal-investments, which consumes resources wastefully for unwanted ends. Since an economy has a finite amount of resources, such wastage means that they will not be deployed in means that really matters. Also, Constantino wrote,

Also the continual and very great fluctuations in the value of money made it very difficult to calculate the costs of production and prices, and therefore also made difficult any rational planning of production. The entrepreneur, instead of concentrating his attention on improving the product and reducing his costs, often became a speculator in goods and foreign exchanges.

Success was the lot not of him who increased the productivity of society’s efforts, thus contributing to the increase of general welfare, but to him who had the capacity for organizing and directing great speculations on the exchange and for using wisely, with the object of personal gain, the variations of the value of money.

The surging asset prices (e.g. stocks, bonds, properties, commodities and yes, even artwork!) of the past several years are not signs of a strong economy. Rather, they are symptoms of inflation, brought about by speculation (see our guide Are Australian residential properties good investments? for an example of such speculation). Indeed, the pain of rising food and oil prices were made worse by hoarding and speculating (see Who is to blame for surging food and oil prices?).

With inflation, there is less incentive to be productive and more incentive to hoard, speculate and gamble. This in turn will reduce productivity and increase price inflation, which further increase the incentive to be less productive. In addition, as we said before in How to secretly rob the people with monetary inflation?, inflation re-distribute wealth unfairly and exacerbate the divide between the rich and the poor.

As time goes by, the economy will be structurally damaged one step at a time. This process can take many decades to completely play out. Of course, with economic mismanagement, it can be accelerated, as in the case of Zimbabwe. Sadly, the world is still committed to inflation.

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