inflation

2008-12-07

What causes inflation, and what is it?

Interactive animated diagrams to be inserted

I've looked into inflation, and it's causes as recent trends have spurred a deeper understanding of the mechanism.

In the simplest of terms, inflation is devaluation of the existing money supply. So all the money that is in the economy is worth less.

Orthodox reasoning will tell you [insert references] that a little bit of inflation is a good thing, too much of it is a bad thing. Deflation, is always seen as a bad thing.

Inflation spurs on the economy by creating an incentive to spend money. If you keep money at home at don't do anything with it, that money slowly looses value. It also means that you need to look for new work and new ventures, because any existing investments will loose value if you don't keep perpetuating the flow of money (velocity).

Inflation also generates an incentive to buy things, because you know that the value of the item will increase, as the value of each unit of currency decreases. So you need to buy things now, rather than later when it is more expensive, again another incentive to perpetuate the flow of commodities.

If there is too much inflation, however, then people will not be able to keep up with the devaluation, and instead of spending money, people will hedge onto assets which don't loose value. This can equate to buying gold, jewelry or a home. Since gold is always retains around the same value, as the price of gold increases to match inflation, so does your value of gold.

However for the economy at large, this is not a good thing, as money leaving the market and being frozen in assets like gold will not keep the money flowing in the economy.

Deflation, where the value of money increases, is generally accepted as being very bad for everyone. The value of money increases, which means that banks loose money on their loans, product which were bought have to be sold for less than they were bought at, creating a loss for the merchants, and the costs of labor increase. The only person who wins from this equation is the consumers, but because they have trouble being hired; because the companies are going bankrupt, they tend to become rapidly unemployed as businesses move elsewhere around the globe.

Because businesses have a hard time running their business, this means that ultimately the gap between people's wages and their ability to meet costs widens; creating economic slow down as fewer and fewer people can afford the costs of living.

When economies are slowing, which occurs in recessions, which is also a deflation, there are generally two solutions to spur the economy forward. You can print more money: inflation; or you can decrease the work-week and raise wages.

Raising wages gives people more spending power, so they are likely to buy more things; however because the economy is slowing, the value of money is increasing, so there is also a side effect that it is beneficial for people to hoard onto their money as it is worth more and more the longer you can hold it. There is an assumption therefor, that wage increases are infective at spurring a return to consumption because they do not directly create an incentive to spend. Increasing the wealth of people essentially decreases their need for other goods and services, because they become autonomous and richer, and therefore there is a decrease in the need to purchase or invest.

It is generally accepted that deflation increases unemployment. By decreasing the work week, employment goes up but the total amount of hours worked per person decreases. This ensures that the benefits of deflation are evenly spread among the people.

Another side effect of increasing wages, is that this will give an even greater incentive to companies to move their employment forces to other countries; where the wages are still lower. This means that while wages would increase, the amount of people employed would also decrease; and the unemployment rate would increase faster than the wages would increase; creating a further worsening of the economy.

In this day and age of a global market, the only way a wage increase/work=week decrease would help to end a recession, would be if wages and work-weeks could be increased/decreased globally. This would create a situation where every person's purchasing power increased, and there would be no alternative market for businesses to use.

Theoretically speaking, a wage increase that was only done in one country would eventually lead to a wage increase in other cheaper wage countries eventually, as their markets boom, competition for employment increase, which increase the average wage, and then eventually the demand for employment would swing back to the original country as their wages would no longer be seen as higher than other countries. The ultimate net result, if you can wait long enough, is for wealth to move from the hands of the wealthy, back towards the people. And every time the demand moves back to the people, deflation, reduction of work-week and increases of wages are guaranteed.

An additional benefit from this deflation strategy is that less and less natural-resources are extracted as the demand on new goods and services decreases in proportion to the increase in leisure time made available to the people. As leisure time increases, opportunities for people to do volunteer work, research, education, artistic endeavors, ecological remediation programs increases. This slow but progressive shift to doing work that one 'believes in' rather than 'must do' to survive would further benefit the earth-system as the total net effort of humanity would shift more-and-more towards beneficial rather than destructive endeavors.

Sadly though the time frame of this wave-bounce-ripple of wage increases is longer than we are willing to accept; and furthermore, this is just not the recourse that governments choose, as by far the most popular recourse a government selects is inflation.

Inflation, the act of printing more money, will also aid an economy to reverse a recession. However the mechanism it employs is the exact opposite of that of a wage increase. The act of printing more money immediately devalues all of the existing money in the economy.

This means that any money you have saved, will become worthless unless you immediately spend it. It also gives you an incentive to buy, because prices are going to increase later, so you had best buy things now before the numbers on the price tag go up. And it also gives you an incentive to work, because any old money you earned and saved, is worth less, so you need to do new work to create new savings at the now higher figure salaries that match the increase of the currencies value. The act of buying things creates a flow of money, which means that there is again demand for work, and the economy picks up again as the money starts to flow once more.

What is vitally important to look at though, is who gets the extra money that is printed.

The most fair and equitable way to create inflation would be to take everyone's money, and raise its value. So if there is 20% inflation, ever person's money in the bank would be worth 20% more. So if you had 1,000 int he bank, it would suddenly grow to be 1,200. However, this would be pointless, because the equilibrium of who has money wouldn't change, and nothing would happen because of the inflation, so this is not how inflation works.

Inflation purposefully creates a dis-balance, the money is given to one area of the market; giving them immediately more value, while other areas of the economy don't receive any money. It is this immediate and direct dis balance that catalysis spending, working, and investments.

In the extreme case where 50% more money is printed, and assuming you are not the one who gets the money, every dollar/pound/euro that you poses is suddenly worth 50% less. A loaf of bread which used to be priced at 1$ is now worth 1.50$ even though you bank account still says only 1,000$

On the other hand, the people who receive the cash-injection suddenly receive value. So if it was given to a bank, and the bank already had 10 billion dollars, and they received a 50% increase in their funds, they would suddenly have 15 billion dollars in their account. Which means that from the banks point of view, the value of bread [and all other commodities, as well as labor] decreases.

This decrease in value is a direct, though perceivable indirect, form of taxation. It is taxation because every person who did not receive a benefit from the cash injection, lost money. That money didn't just disapear, it went directly to the people who received the cash addition.

With this understanding then, it is possible to look at things the other way around. Deflation is the direct result of people having more spending power; which decreases the ability of companies to afford labor, and thus slows the economy. Inflation is the act of taking money away from the people, which lowers the value of labor, and thus makes companies more profitable, which means that we can have more goods, and makes the person at the bottom of the employment-pool employed, but for less wages. Inflation forces people to work more, deflation encourages people to work less to meet basic needs.

The reason that inflation works to generate more wealth, is that it creates the incentive for people to work. Working is the direct application of human effort to transform materials from lower order to higher order goods and services. The act of making a tree into pulp into paper, is the act of taking a real-world asset, transforming it into a product, and then selling the product, and then using it.

It is the act of transforming natural resources into goods and services that generates wealth. Innovations help to increase the efficiency of that transformation, and the pressure to work helps to perpetuate this process of transformation.

The process of inflation creates the 'stress' that speeds up economic processes. You make people need to work more, which generates more money, which derives its value from more transformation of natural resources, which increases humanities impact on the natural world.

At a natural state of equilibrium, where man would live sustainably on the earth and not exhaust resources, the rate of transformation of natural resources would not exceed the rate of natural regeneration. The efficiency of transformation can be increased, which is a technological/intellectual evolution. But this is the only real economic growth that can be obtained from a sustainable system other than the actual application of long-term investment in natural resources.

This is because any decrease to natural capital, at a rate that is higher than its ability to regenerate, is a non recoverable decrease in that systems future ability to provide output.

If you had 100 trees, and 10 trees are regenerated every year, a regeneration rate of 10%, then if you cut only 10 trees a year, you will always have 100 trees at the end of the year [100 trees + 10 trees (10%) - 10 trees cut).

If you had 100 trees, and 50 trees are cut in a year, then the most trees that you could have are 60 trees: 100 trees + 10 trees (10%) - 50 trees = 60 trees. Technically the regeneration rate would be lower as you are cutting trees, and the regeneration rate is also higher than 10% because there is now more open space for seeds to germinate in, but the gap between regeneration and maturity is not 1:1; meaning that if you exceed the regeneration rate, the rate of regeneration will never match the rate of extraction.

If deflation were to be allowed to run its course, and instead money were to be given to the people, not to the companies, and that money were to be taken as a taxation to the companies and people who had the most money, then it would mean that the people would require less goods and services, therefore there would be less economic pressure to extract natural resources, and less need for employment. There would be less wealthy, but there would also be less poor too. And if followed as a global trend, the average wage of all people would increase, steadily giving people more economic autonomy, and moving wealth from the wealthy, to the poor, while also reducing man's impact on the natural environment; as less goods and services would be produced.

Since real long term wealth is only created from the following:

  • natural capital investment (planting trees, repairing coral reefs, increasing bio-civersity, cleaning rivers)
  • eduction (increases people's ability to tackle more complex problems)
  • innovation (increasing the efficiency of systems, and transformations)
  • autonomy (decreasing one's living costs, assuring security of home/food)

Every attempt should be taken by all economies to decrease wealth in the hands of few, and instead focus on investing in long term natural capital, education, innovation and assuring the basic needs of all people.

Since governments represent the people, and not the companies, it is the people who should be benefiting from economic activities, not the companies. Increasing the the rate of money flowing in the economy, to a rate that is higher than natures ability to replenish her resources, is to drive short-term unsustainable wealth, at the expense of long term wealth, and at the expense of forcing people to invest more and economies to work faster.

In conclusion, because inflation is a taxation, people need to realize that money is directly leaving their pockets. Yes, the economy is stimulated, but the only reason it is stimulated is because the value of your work decreases, which means that more natural resources can be extracted for short term applications. So the only reason that things appear better, is because you are directly withdrawing from the worlds long-term savings to meet immediate concerns.

An analogy would be to take a situation where someone has a machine that transforms wheat into bread. If deflation is occurring, it means that even though you used to be generating 10 loafs of bread for every 10 pounds of wheat, because of your costs: rent, taxes, fuel etc.; you don't actually create enough bread to feed everyone. Inflation means cheaper labor, which means you can transform more goods, so the cost of planting and cutting wheat decreases, which means you can have more wheat. So your solution is to decrease the value of the wheat, so that you can now buy more wheat for less, and this means that you can now produce 20 loafs of bread from 20 pounds of wheat, which now means you can cover your costs and pay taxes and buy fuel.

This doesn't mean you generate more wealth, it just means you generate more extraction of natural resources.

Another common argument is that the more people are working, the higher the rate that money is flowing (velocity), the greater the innovation, and the more competitive your market thus is to other competitive markets. The increase in competitive advantage is totally true, however, this is done at the expense of the planet's long term capital. As markets compete, and scale up, they need to transform ever greater commodities in order to compete with other markets; creating a 'commodities-race'; much like an arms race [if not a direct arms race], injuring the sustainability of both markets long-term viability.

While innovate is certainly stimulated by competition, it is not the competition per say that stimulates innovation, but the support that ideas receive that allows innovations to be implemented. It is 'will' applied to 'method'. Innovations are typically driven by 'needs'; when markets are forced to compete, needs are modified into sales-advantages. There is no reason why governments, synonymous with people, can't focus on stimulating education, selecting innovative individuals, and then facilitating their ideas with collective funds that would allow individuals to implement their ideas. So instead of having innovation be a side-effect of economic competition, it could be the social-structures' direct incentive. As each new invention increases our transformational-efficiency. Refrigerators, auto-making machines, computers; all of these inventions allow us to do more, with less. They increase wealth by facilitating better, or higher order, transformations. Ultimately benefiting mankind as each individual needs to employ less and less effort to maintain equilibrium since more and more higher order results are achieved from transforming the same quantity of resources.

The only reason markets don't work this way, is because we are focused on promoting business, not individual-wealth. We focus on 'trickle down' economics, and give breaks to those who manage to get to the top, and the higher you are, the more taxation, interest, inflation and debt you can push to the bottom, or maneuver from foreign markets. We need to see the connection between the higher the pyramidal structure we support: the higher the degree of natural resources [transformations] we require.

And since we need to measure our rate of resource use to match our needs, not to exceed it, all of our current market principles are unsustainable by the very nature of their design.

so I urge you, please say no to inflation. The next time you see your economy going into a recession, demand instead a broad-reduction in the work-week and an increase in your wages.