IT HAS BEEN SAID that affliction is a school of virtue,
that it corrects levity and interrupts the confidence of sinning. If
this should be true, then the rampant inflation which is our most
serious public affliction should offer important lessons in virtue and
hamper the confidence of economic sinning. But such lessons cannot be
learned as long as ignorance deprives man of some basic understanding of
his affliction and of the remedies there are.
For hundreds of years the issue of excessive quantities
of paper currency by government was called inflation. Rising goods
prices were deemed to result inevitably from such issues and were
thought to offer an indication or measure of the degree of monetary
inflation. But in the semantic confusion of our age we are calling the
rise in prices inflation. And the issuer of the money, spendthrift
government, is called "inflation fighter."
How delightful and profitable for officials and
politicians! They can spend and spend without much worry about budget
deficits, which are covered by the issue of new currency. The new
terminology implicitly lays the blame for rising prices on anyone who
dares to raise his prices, on "greedy" businessmen and workers,
speculators and foreigners. But the confusion brings havoc and poverty
to countless victims whose incomes are greatly reduced and savings
destroyed. It impoverishes the "middle class" with its savings for the
rainy day and retirement.
Inflation is sometimes described as a tax on the money
holders. In reality, it is a terrible instrument for the redistribution
of wealth. It is true, the government is probably its greatest profiteer
as its tax revenues are boosted by the built-in progression in higher
income brackets and through the depreciation of governmental debt. But
in addition, the inflation shifts wealth from those classes of society
who are unable, or do not know how to defend themselves from the
monetary destruction, to entrepreneurs and owners of material means of
production. It strengthens the position of some businessmen while it
lowers the real wages of most working men and professionals. It
decimates or destroys altogether the middle class of investors who own
securities or hold claims to life insurance and pension payments. And
finally, it gives birth to a new middle class of traders, speculators,
and small profiteers of the monetary depreciation.
Massive Redistribution
The magnitude of the present redistributive process in
the U.S. can only be surmised. Let us estimate the total volume of
public and private debt at $2.7 trillion (Federal $475 billion, state
and local government $200 billion, corporations $1150 billion, farms $80
billion, residential mortgages $400 billion, commercial mortgages $75
billion, other commercial debt $55 billion, financial debt $65 billion,
consumer debt $195 billion). A ten per cent rate of dollar depreciation
transfers $270 billion a year from the creditors to the debtors. A
fifteen per cent rate, which better reflects economic reality, would
transfer $405 billion per year. Now, disposable personal income in the
U.S. is estimated at $931 billion (cf. Federal Reserve Bulletin, July
1974, p. 57), which makes the inflation transfer income and loss nearly
44 per cent of annual incomes from productive services. In short,
present inflation as a powerful instrument of wealth redistribution is
responsible for a stream of income and loss equal to almost one half of
our productive efforts.
The redistribution process is also a massive debt
liquidation process in real terms. Surely, the nominal magnitude of
dollar debt is rising, but in terms of real things and real values debt
is being liquidated at the depreciation rate. A ten per cent rate of
currency depreciation reduces real debt by ten per cent; total monetary
destruction destroys debt totally. It transfers the ownership of real
wealth from the people who have lent money to the people who have
borrowed the money.
Such are the profits and losses from only one source:
the currency depreciation that gives to debtors that which it takes from
creditors. In addition, several other inflation factors inflict huge
losses on nearly all classes of society.
Rampant inflation destroys the capital markets which
are the very well-spring of productive enterprise. Having suffered
staggering losses through depreciation, few lenders are able to grant
new loans to finance business expansion or modernization, or merely
current operation. And even if they had the f unds, they are reluctant
to enter monetary contracts for any length of time. Business capital,
especially long-term loan capital, becomes very scarce, which
precipitates economic stagnation and recession. Similarly, businessmen
begin to hedge for survival, investing their working capital in
inventory and capital goods. Funds that used to serve consumers become
fixed investments in capital goods that may escape the monetary
depreciation. Economic output, especially for consumers, thus tends to
decline, which may raise goods prices even further.
A great deal of "unproductive" labor is needed to cope
with the complexities of calculation and dealing with rapidly changing
prices. Cost accounting faces the insoluble task of calculating business
costs with a yardstick that is shrinking continually. Managerial
decisions become very difficult and enterprise efficiency is greatly
hampered, which raises business costs and reduces output.
Finally, the greatest danger to economic production and
well-being looms in sudden government intervention. Having recklessly
depreciated the currency at two-digit rates, the same government may
want to legislate and regulate the economic actions of the people. It
may suddenly impose price, wage, and rent controls, restrict imports or
exports, levy new taxes, or commit some other folly, all in order to
treat some symptoms of its own policies.
Real Wages Fall
Two-digit inflation tends to reduce the real wages of
nearly all classes of employees, from unskilled laborers to chief
executives. While many goods prices can be adjusted quickly to the
monetary depreciation, wage and salary contracts are written for longer
periods of time, often for a year or even longer. During this time
employees suffer a continuous erosion of real incomes and standards of
living. It is true, the reduction in real wages, which are business
costs, tends to raise the demand for labor, which generally causes
unemployment to decline. Also, profitable enterprises that continue to
compete aggressively for labor tend to review wages and salaries more
often than before, for instance, every six months instead of waiting two
years. Others boost merit pay substantially to avoid rising costs
through higher turnover.
The general decline in real wages tends to breed
widespread labor unrest. Individual productivity may fall substantially
which raises business costs, reduces output and thus boosts prices even
further. Labor unions react by demanding large increases in nominal
wages, and sometimes may succeed in restoring real wages at least
temporarily, until the inflation again reduces real wages, fol. lowed by
further union demands, and so on. Ugly strikes multiply, costing
millions in work hours, inflicting business losses and raising costs,
and thus generating ever greater pressures for higher prices. In
desperation many millions of heretofore unorganized employees are led to
joining unions or forming collective strike organizations in order to
avert the loss of real wages. Labor unions seem to thrive on monetary
depreciation and the economic conflict it generates.
Rampant inflation also affords growing popularity and
public support of a system of wages based on a cost-of-living index,
commonly called indexation, All wages may be fixed according to an index
number calculated by a government bureau. Of course, even such a system
cannot be expected to protect labor from the disastrous influences of
monetary depreciation as the index is calculated on the basis of past
prices that differ from goods prices when wages are paid and spent.
General indexation of wages also works havoc upon those industries that
suffer severely from the inflation, such as consumers' goods industries
and service industries. They may contract further, reducing output and
service, which again raises prices.
The Poor Suffer
The poorest classes of society living closest to the
subsistence minimum are hurt most severely by monetary depreciation.
Especially those poor who live on fixed incomes, such as pensions and
annuities or welfare gratuities that are slow to adjust to the rise in
prices, may actually experience deprivation and hunger. Others may be
forced to supplement their shrinking purchasing power by seeking
employment if this should be possible. Thus, some unskilled labor that
used to prefer public support over working for a living will return to
productive employment. Others may resort to vice and crime to bolster
their falling incomes.
Real incomes of civil servants, military personnel, and
salaried employees of commerce and industry may fall even faster than
those of the poor. True, they may not immediately face deprivation and
hunger, but they may be greatly reduced and impoverished by the rise in
goods prices that tends to exceed their occasional salary adjustments.
The situation may even be worse with professional men,
such as physicians and dentists, attorneys, artists, writers, and
professors at private institutions of learning. Rampant inflation may
reduce them to a life of penury and misery as public demand for their
professional services tends to decline significantly with the general
impoverishment of the populace. After all, demand for their services is
much more elastic than that for food, for instance, which explains why
less money is spent on professional services in spite of ever larger
government expenditures on health, education and welfare.
The suffering of this professional class is compounded
by the destruction of its savings through inflation. In general, the
middle class generates the financial capital that affords productivity
and expansion to commerce and industry. It holds a large share of
national wealth in the form of financial capital, such as corporate
stock and debentures, demand and time deposits, life insurance, pension
funds, and the like, all of which suffer serious losses from the
depreciation of the currency. In fact, rampant inflation expropriates
the wealth and substance of this middle class.
Dangerous Stock Markets
The stock market offers great opportunities during
periods of rampant inflation. Industrial shares especially are subject
to extreme fluctuations in price, which astute traders will use to their
advantage. This does not mean that the market offers investors a
reliable hedge against inflation. On the contrary, the real value of
shares tends to decline, which inflicts considerable depreciation losses
on share owners. But alert traders can profit from the many chills and
fevers that attack the market.
The greatest factor of change that virtually shapes the
price trends is the monetary policy of government. Large bursts of money
creation and credit expansion are followed by sudden jerks of restraint
or even stability, which trigger symptoms of economic recession and
decline. Or, the government may suddenly impose price, wage and rent
controls, or resort to other means of intervention that temporarily
reverse the trend. To ignore the everchanging signals of monetary policy
and other government intervention can be very costly.
In terms of purchasing power, stock prices tend to
decline because most business profits are more apparent than real. The
sums set aside for maintenance of equipment, called depreciation, are
mostly insufficient. Replacement costs soar while depreciation that is
allowable under the tax laws is based on past costs and therefore
insufficient to cover present costs. In fact, many profits are
fictitious, which causes companies to pay income taxes although there is
no income, and declare dividends while working at a loss. Similarly, the
inflation profits on inventory are mostly fictitious as replacement
costs may equal or even exceed the proceeds of a sale that was believed
to be profitable.
During periods of rampant in-flation it is very
difficult, even for experts, to ascertain the profit-ability of an
enterprise. To interpret profit statements and balance sheets becomes
nearly impossible, which affords companies an opportunity to hide their
earnings or losses and show only what they want to show. For an investor
to appraise the value of his corporate shares becomes an insoluble task.
Occasionally the monetary au-thorities may slow down or
even abstain from creating more currency and credit. Or their rate of
expansion may fall short of that expected by businessmen. In each case
the fevers of inflation are interspersed with the chills of recession
and depression, which send stock and bond prices tumbling until, once
again, the Federal Government comes to the rescue with record budget
deficits and new bursts of currency expansion. After all, this is the
basic recipe of the "new economics" that has shaped Federal economic
policy since the 1930's and has given us "inflationary recessions,"
i.e., simultaneous inflation and reces-sion.
No Sure Hedge in Fluctuating Stocks
When one or several of the stated factors depress stock
prices the public may realize that even the purchase of industrial
securities affords no safe means of investing their savings. Suffering
heavy losses, they withdraw from the market and invest their remaining
funds in goods or money market instruments, especially Treasury
obligations. The public is the "middle class" of some 30 million
stockholders and 50 million investors who indirectly own corporate
securities through investment companies, pension funds, life insurance
companies, credit unions, and so on. They suffer heavy losses when they
finally liquidate their stock investments for depreciated currency. It
has been estimated that since 1965 most American stock investors have
lost at least 40 per cent of their savings through price declines and
another 40 per cent through currency depreciation.
From time to time the fever of inflation may cause
stock prices to soar as the monetary authorities refuel the money
markets in order to avoid depression and unemployment. The investor may
rejoice about his long-awaited profits. Deluded by the apparently high
prices he may be induced to sell his securities. Unfortunately he may
not be aware of the real losses which the monetary depreciation is
inflicting on him. Again he loses severely in purchasing power and real
wealth, and yet may have to pay an income tax on the nominal profits he
earned.
The speculator who observes the merciless drubbing of
most investors has learned to distinguish 14apparent profits" from
"real" ones. He trades with the trends of the market, jumps from
industry to industry, always seeking action and quick profits. But above
all, basically he is a buyer of the securities that are liquidated by
the middle-class investor. The monetary depreciation which greatly
reduces their real price makes it easier to acquire securities. Thus, we
can observe not only a gradual shift of corporate wealth from the old
class of capitalists and middleclass investors, but also a concentration
of industrial shares in fewer and fewer hands. A small new middle class
of traders and speculators replaces the old middle class of investors,
and huge new fortunes are created from the losses suffered by investors
and capitalists.
The depreciation of public debt and the fall of
industrial securities in terms of both price and purchasing power strike
a devastating blow not only at millions of small investors but also at
great capitalists whose wealth is invested in marketable securities.
Wealthy stock brokers, bankers, financiers, renters, heirs, or
businessmen in retirement who before the inflation owned large fortunes,
that is the "old rich," suffer serious losses. Old fortunes vanish, and
eminent family names fade away. Similarly, the wealth of charitable
institutions, religious societies, scientific or literary foundations,
and endowed colleges and universities, is destroyed by inflation.
Losses in Real Estate
While inflation inflicts havoc on monetary investments,
it has varied effects on property of land and buildings. Agriculture, on
the whole, survives a period of feverish inflation rather well. Farmers
generally profit from the increase in prices of agricultural goods and
from the depreciation of farm mortgages. Even small and middle-size
operators whose debt may render their independence rather precarious in
normal times can hold their own during rampant inflation. After all,
they are the producers and owners of real goods the prices of which
rise, yielding ever higher incomes, while inflation reduces the real
burden of their debt.
Ownership of residential housing offers a much poorer
defense against inflation than is commonly believed. Although mortgage
debt is greatly reduced by the inflation, which affords some inflation
profits to owners, the market price of private residences and commercial
property usually limps behind the rate of monetary depreciation. During
rampant inflation interest rates soar and mortgage loans are hard to
find, which makes it rather difficult to finance a purchase. Thus,
effective demand may be reduced which tends to depress real estate
prices. This is especially true for middle class housing whose owners
feel impoverished and in need of retrenchment. It may not be true for
beautiful mansions and large estates that continue to sell at high
prices to a new class of nouveaux riches.
But even when real estate appreciates in price and the
owner gains from a sale, on which he must pay a capital gains tax, he
may lose in terms of purchasing power. Deluded by apparently high
prices, many owners may be induced to sell their homes, to realize only
much later, perhaps, that they made a poor bargain.
The situation is most dangerous and precarious for
apartment house owners. They are vulnerable not only to the
imponderables of a feverish capital market, to the impoverishment of
their working and middle-class tenants, and to the price delusion
mentioned above, but also to the ever-present danger of rent control, A
desperate government may do desperate things. Drawing wrong conclusions
from given facts and fighting symptoms rather than causes, it may by
force arrest prices, wages and rents. But rent controls imposed for
prolonged periods of inflation reduce real rents significantly, which
causes house prices to fall accordingly. With maintenance expenses
rising, real rents falling and losses looming, many owners may be forced
to sell out-at very low prices. And again, the class of old investors
makes room for a new class of speculators who at bargain prices are
buying a great many houses.
But even without controls rental property may be
depressed because working and middle class demand for housing is
shrinking as real income is declining. Or, many apartment house owners
may not realize the significance of the monetary depreciation, and
therefore are slow to adjust their rents. Or, they may be reluctant to
raise rents for charitable reasons. In each case the yield from such
property tends to decline, and therefore also real estate prices, which
may inflict serious losses on its owners.
The Nouveaux Riches
Huge private fortunes and imposing concentrations of
capital are formed from inflationary redistribution. But in contrast to
the formation of capital under stable monetary conditions, when fortunes
are built through productive changes and improvements, through
technological inventions and efficient methods of production, the wealth
derived from inflation is "redistributive," from one individual to
another. The new millionaires are not generally creators of new
industries or reorganizers of production. They are mostly clever
speculators with excellent understanding of monetary policy and its
effects on stock prices, exchange rates and high finance. They may even
be industrialists who are turning away from the hard work of business
management to the more rewarding dealings in securities, commodities and
foreign exchange. But above all, they understand the phenomenon of
inflation and use this knowledge in all their financial operations.
As speculators they endeavor to render the most urgent
economic service needed at the time. They are quick to adjust their
resources to the rapid changes in prices and markets that suffer from
chronic maladjustments due to the ever-changing monetary scene. Thus
they facilitate quicker and smoother readjustment and better allocation
of economic resources to the most urgent needs of the public.
During rampant inflation one of the rules of good
management is to contract as many productive debts as possible. The
speculator borrows other people's money, which is repaid later with
depreciated currency. Instead of keeping large bank deposits he finds it
more advantageous to incur the highest possible debt with his bank. Of
course, at all times he must maintain his liquidity to meet current
obligations, always guarding against sudden calling of loans by his bank
in moments of extreme credit stringency.
Inflation not only destroys income and wealth, but also
redistributes them from millions of creditors to many debtors. Some
businessmen, especially the young, aggressive entrepreneurs, understand
this principle and utilize it to their advantage. They expand their
enterprises or acquire new ones, merge with others or form new business
structures - always building on debt. The inflation losses suffered by
banks and bond holders who finance the expansion accrue as profits to
these entrepreneurs who join the class of nouveaux riches. But
occasionally when the government reverses its monetary policy, when it
deflates rather than inflates or when it merely reduces the rate of
monetary depreciation, these entrepreneurs may find themselves
overextended. They may have to contract their operations, or liquidate
some of their holdings. In fact, some may lose their fortunes even
faster than they were made.
Chills and Fevers
Financial survival is especially difficult as the
fevers of inflation are interspersed with the chills of recession. Some
industries may be seized by the inflation fever while others may suffer
recession symptoms. Rampant two-digit inflation does not follow the
simple pattern of earlier moderate inflation, which tends to generate
economic booms that are followed by periods of recession. Instead, it
causes such serious disarrangement of markets and disruption of
production that both economic disorders occur simultaneously.
The rapid depreciation of the money virtually destroys
the capital market. The supply of loan funds tends to shrink as lenders
are fearful of suffering losses from the depreciation of the money.
Capital-intensive industries and others that depend on long-term
financing, therefore lack the necessary capital for expansion,
modernization, or merely maintenance of costly capital equipment. The
strength and substance of such industries may deteriorate, their capital
being gradually consumed. If, in addition, these industries are enmeshed
in government rate setting and price fixing, they may wear out quickly,
which becomes visible in the deterioration or even breakdown of service.
Obviously, the equity markets of these industries tend to be depressed
throughout the rampant inflation.
Also consumers goods industries, in general, tend to
contract throughout this period. After all, most consumers suffer losses
of income and wealth and, therefore, are compelled to curtail the
consumption of goods they deem least essential. Vacations may be
postponed or at least shortened. Expenditures on entertainment,
amusement, and other "luxuries" may be cut. There may even be reductions
in the quality of essentials, such as food, clothing, and housing. And
instead of seeking education in private institutions, the children may
attend public schools, and state or community colleges.
The only industries that thrive on rampant inflation
are the cap-ital goods industries. They are producing the goods that
permit business to hedge against the inflation through investments in
new tools and equipment, or larger inventories of materials and
supplies. As inflation reduces the real costs of labor, many businesses
endeavor to accumulate capital in the form of durable assets, preferably
those that are expected to appreciate in value while retaining some
degree of marketability. Many companies use their own working capital or
seek bank loans to increase their inventories or add to tools and
equipment, which can be expected to rise faster in price than the
interest costs on the capital invested. They sacrifice liquidity in the
hope of higher profits from the expected rise in prices.
Boom and Bust
All these specific symptoms of rampant inflation tend
to conceal the most important predicament that affects everyone: the
boom and bust cycle that is generated by the inflation. When the
monetary authorities first expand the money supply in order to finance
Federal deficit spending or stimulate the economy they set into motion
certain forces that seriously distort the allocation of productive
resources. Specifically, the policy of easy money and credit temporarily
reduces interest rates, which causes businessmen to invest more funds in
new construction, machinery, equipment, and raw materials. It generates
a feverish boom in the capital goods industries with rapidly rising
prices of labor and resources. Now, this boom built on easy money and
credit must come to an end as soon as the rising prices of labor and
resources, which are business costs, erase profit margins or even
inflict losses. After all, the boom must end as it was artificially
built on paper and credit only. The, recession that follows permits
markets to return to normal, in particular, capital goods prices to
decline, the industry to contract again, and the consumers goods
industries, which were neglected throughout the boom, to come into their
own again.
But this cycle can be extended in duration and be made
more severe in its fluctuations through new injections of money and
credit. Or merely the anticipation of new injections may cause
businessmen to reduce their cash-holdings and escape into real goods.
Thus, the boom may continue to rage even though the monetary authorities
may cease temporarily to add new money and credit, because businessmen
have come to expect an early resumption of monetary expansion. Once
capital goods prices rise at two-digit rates, a temporary halt in the
expansion process does not signal an end of the boom that continues to
be fed by businessmen's reduction in cash-holdings. Although interest
rates may soar and the costs of financing equipment and inventory rise
significantly, capital goods prices are rising even greater. It pays to
order and buy now rather than wait until prices have risen again.
The expectation of an early resumption of easy money
and credit that keeps the fires of boom burning is solidly based on a
political assumption: that government will soon inflate again in order
to alleviate some consequences of its earlier inflation. Alarmed about
the recession that is engulfing the consumers' goods industries, it will
want to stimulate once again these industries. When consumers are fast
losing purchasing power during two-digit inflation, consumers' goods
industries suffer symptoms of contraction and recession, especially
unemployment of capital and labor. But by popular demand government is
expected to cope with this recession with all means at its disposal.
That is, it is expected to resume deficit spending and credit expansion
in order to restore full employment. The economic boom thus burns on
with new money and credit.
From Bad to Worse
In the ideological climate of today there can be no
genuine reversal of monetary policy. The two-digit inflation must rage
on, feeding an ever hotter boom of the capital goods industries and
aggravating the recession in the consumers' goods industries. The
purchasing power of the dollar must fall at ever faster rates, being
depreciated by ever larger injections of money and credit and a growing
expectation thereof. Two-digit inflation only comes to an end with the
advent of three-digit inflation which signals the approaching demise of
the paper currency. In the final convulsion of inflation fever, millions
of housewives join businessmen in a panic rush to exchange their rapidly
depreciating money for real goods. When millions of consumers hurry to
spend their monetary assets and use all their lines of credit in order
to seek refuge in real goods, the end of the currency comes in sight.
Consumers' goods prices that were rising at much lower rates than those
of producers' goods then will soar to catch up with the latter, or even
surpass them, in the final contortion of the crack-up boom. In the dusk
of the paper system that springs from political power and economic
redistribution, the dreaded depression that was so long delayed in
coming will finally make its entrance with irresistible force. Thus,
once again, the inexorable laws of economics will prevail over political
intrigue and power.
Indeed, affliction is a school of virtue that may
correct levity and interrupt the confidence of sinning. But how long and
how often must man be afflicted before he learns the lesson?
At the time of the original publication, Dr. Sennholz
headed the Department of Economics at Grove City College and is a
noted writer and lecturer on monetary and economic affairs.
Reprinted with permission from The
Freeman, a publication of The Foundation for Economic Education, Inc.,
January, 1975, Vol. 25, No. 1.
Yourname@libertyhaven.com
