The Effects of Inflation

By: Steve Saville | Mon, Apr 27, 2009
Print Email

Below is an excerpt from a commentary originally posted at on 26th April 2009.

The Effects of Inflation

The effects of monetary inflation are three-fold. First, it brings about an unwarranted transfer of purchasing power (resources) to the creator of the new money and/or the first user of the new money. Another name for this unwarranted transfer is theft. Second, it has a NON-UNIFORM effect on prices, leading to mal-investment and the wastage of resources. The huge amount of savings and resources squandered in real-estate investments over the past several years exemplifies the havoc that can result from monetary inflation and why its effects cannot simply be counteracted at some later time by "withdrawing liquidity". Third, it EVENTUALLY results in a broad-based increase in the prices of everyday goods and services.

Almost everyone focuses on the third of these effects, but the greatest injustices and economic problems result from the first two. The "Keynesians" and the "Monetarists", for instance, are generally unaware of the first two effects. In their fatally flawed views of the economic world, monetary inflation either doesn't matter at all or doesn't matter unless/until it causes the CPI to rise.

Based on traditional lead times, the substantial monetary inflation that has occurred over the past seven months probably won't start to become evident in the prices of everyday goods and services until 2010. Furthermore and as mentioned in previous TSI commentaries, the CPI will probably trend downward throughout 2009. This will make the deflationists look right for the next few quarters even though they will be wrong. They will be wrong because even while prices decline, the inflation will be taking a heavy toll on the economy by facilitating the transfer of resources to the government and to failed businesses. The Keynesians argue that the monetary inflation won't be a problem because the economy will remain weak due to "insufficient aggregate demand", but they fail to realise that "insufficient aggregate demand" doesn't cause anything* and that monetary inflation is one of the main reasons why the economy is destined to remain weak.

We are far more bearish on economic growth and employment than the mainstream economists who are predicting deflation, and yet we expect an upward trend in the general price level to begin within 12 months. Our expectation is not outlandish because economic weakness will not prevent a currency from losing its purchasing power in response to substantial growth in its supply. In fact, it's the other way round. The less stuff that gets produced by the economy the greater will be the eventual decline in the currency's purchasing power stemming from monetary inflation. Or, to put it another way, real economic growth puts downward, not upward, pressure on the general price level, so during periods when the economy is weak there will be greater potential for increasing currency supply to bring about higher prices (after the usual 'confusing' lag, of course). During 1933-1940, for example, the unemployment rate was stuck in the 14%-20% range and yet prices trended upward in response to a moderate increase in the money supply (the US Government/Fed couldn't increase the money supply at will during this period due to the remaining vestiges of the Gold Standard). Prices also trended upward in parallel with high unemployment during the 1970s, again due to growth in the money supply.

The effects of monetary inflation will work their way through the economy over the next few years, but the theft is happening right now. We suggest that the deflationists stop going on about how the amount of money created 'out of thin air' is small compared to the declines in asset and debt prices (and thus encouraging the Fed to counterfeit money at an even faster pace), and start emphasising the problems inherent in the inflation.

*Aggregate demand will never be "insufficient" until everyone has everything they want, which means it will never be insufficient. What Keynesian economists refer to as "insufficient aggregate demand" is the increased tendency to save, and the corresponding reduced tendency to spend, after savings have been obliterated on a grand scale due to the mal-investments prompted by the preceding inflation-fueled boom. A fall in prices is one of the ways the economy heals itself in the aftermath of an inflation-fueled boom. Generating more inflation prevents the healing process from occurring.

Current Situation

Either through luck or skillful manipulation, the Fed has managed to bring about a sizeable increase in the US money supply over the past seven months while preventing the money supply growth rate from spiraling out of control. At the beginning of this year there appeared to be a significant risk that the monetary situation would spiral out of control, but things have since settled down. For example, US M2 money supply is down by around $100B over the past four weeks and is almost flat over the past 11 weeks, causing the year-over-year M2 growth rate to drop back from 10% to 8% (we haven't re-calculated TMS, but the TMS and M2 growth rates have tracked each other closely over the past several months).

The year-over-year growth rate in the money supply is likely to resume its upward trend over the coming months, though, because the Fed is likely to ramp-up the rate at which it monetises bonds. In fact, such a ramp-up appears to be underway in that the Fed monetised (purchased with newly created money) $75B of mortgage-backed securities and $14B of Treasury Bonds during the week ended 22nd April.

We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at:



Steve Saville

Author: Steve Saville

Steve Saville
Hong Kong

Steve Saville

Regular financial market forecasts and analyses are provided at our web site:

Also, samples of our work (excerpts from our regular commentaries) and additional thoughts on the financial markets (and other stuff) are provided at our blog:

Copyright © 2003-2016 Steve Saville

All Images, XHTML Renderings, and Source Code Copyright ©