This article follows on from my previous one, entitled What Really Causes Poverty? A Look at Monetary Inflation. If you have not read it, it may be useful to do so in order to understand the context and background of this piece.
Undoubtedly, most of you have some sort of idea about what inflation is; I’m sure that, in your mind, you may have answered the title question with a response along the lines of, “inflation is the general rise in the prices of goods and services over time.” This is all well and good, but if we accept this as a definition for inflation, another problem arises: how do we explain this perpetual rise in the prices of goods and services?
Fortunately, this problem does not need to be solved, because this definition of inflation is actually incorrect. Hence, the real definition of inflation:
Inflation is the increase in the supply of money. In our context, it means that more Rands are entering the ‘economy’.
Before explaining how this works, I want to highlight a recent event in the news; it will hopefully become relevant and understandable if I succeed in explaining the inflation phenomenon correctly. Recently, the reserve bank governor, Gill Marcus, announced that the repo rate [1] would remain unchanged. Much of her announcement was dedicated to ‘inflation,’ that is, rising prices [2]. I would imagine that, to some of you, this makes no sense – how would the prevailing interest rates between banks affect what you and I pay for simple goods, such as food or petrol? Keep this in mind as I continue the inflation explanation.
Since I stated that inflation is an increase in the money supply, and not CPI (which is a measure of prices), we need to begin by considering how the money supply is increased – cue the South African Reserve Bank. This institution has total control (a legal monopoly) over the issuance of our currency, the South African Rand. Thus, any increase in the supply of money that cannot be attributed to fractional reserve banking (which I will not discuss here), must necessarily be attributed to the reserve bank.
This, of course, conjures another question: why, and how, does the reserve bank create new money? It does this to help commercial banks. In order to understand this, I am going to begin with an illustration from the financial world.
Every government, such as ours, accumulates debt. Like any normal person, the government sometimes (in truth, almost always) needs to borrow money. Of course, this happens on a substantially larger scale. So, when the government needs money, it goes to the ‘market’ to find people who will lend it money. After finding a lender, the government receives a big pile of cash and, in return, gives the lender a certificate (or contract, if you will) which promises that it will pay the lender back in full with interest. The government gets the money, and it issues a ‘bond’ or promise to the lender to pay back their money; the lender thus purchases a bond.
This happens daily, and as a result, the financial world now has something called the bond market. Investors and banks lend to government and receive bonds (promises to pay back money), and these investors and banks also buy bonds from others who have lent to the government.
This is where the reserve bank comes in. When a bank lends money to the government, it, of course, has to hand over cash which it can thus no longer use. The remaining cash in their vaults or on their computers is used for lending to businesses and others. Now, as per the laws of supply and demand, a diminished supply of loanable funds (assuming a constant demand) drives the price of the funds higher. To you and me, this is the interest rate.
The reserve bank wants to keep everyone happy. What they proceed to do is replenish the volume of loanable funds in banks. In order to do this, and this is key, they have to print new money. From there, they buy bonds (and other similar financial instruments, such as mortgages) from the banks, rather than directly from the government, and the banks charge a premium for the sale. As a result, the banks now have a much greater supply of funds which they can, in turn, loan to people and businesses. This greater supply in loanable funds reduces the ‘price’ of borrowing, that is, interest rates, and interest rates thus come down across the board.
This sounds fantastic, except we must consider the effect of increasing the supply of money. I will not go into this too deeply but simply, as I explained in my last article, an increased supply of money chasing the same goods and services as before is what causes prices to rise; there is an increase in monetary demand for these items. Think of it as a scale; on the one side, you have a pile of bank notes. On the other side, you have some food, clothing, petrol and various other goods. When you add new bank notes to the applicable pile, the side with the bank notes becomes heavier, and causes the lighter side – the side with the goods – to lift up. In other words, goods become more expensive.
Hopefully, what we can see from these explanations and examples is that the SARB’s stated link between influencing interest rates (which involves the creation of new money) and causing prices to generally rise actually makes sense. This also indicates, to some extent, that they are aware that their policy decisions have these sorts of effects.
Thus, to conclude, inflation is not a natural phenomenon that spontaneously takes place in the economy. It is the consequence of very deliberate action undertaken by reserve banks, such as the SARB. It is also a form of wealth redistribution (see my previous article), since the banking industry is the first to benefit from money expansion, and thereafter those who receive cheap credit, and so on. In order for someone to benefit, someone else, in this instance, loses out – everyone whose income does not adjust to compensate for monetary inflation. Frankly, many people are clueless about this phenomenon. I was somewhat amused, and also shocked, when Rick Santorum, in his bid to gain the Republican nomination earlier this year, answered an evidently knowledgeable journalist about the issue of inflation and its necessity; his response, which demonstrates his absolute economic ignorance, was, “Well I think we need inflation. Just a little bit of inflation to keep the economy going.”
The truth is that we do not at all need inflation.
In the following excerpt from Economic Policy, Mises writes:
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.” [emphasis added]
[1] The rate at which commercial banks ‘borrow’ from the SARB
[2] http://www.fin24.com/Economy/Petrol-food-prices-main-inflation-risks-20120920
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