Part 5.2: The inflationary process and the economic effects of inflation

Inflation has further pernicious consequences: It distorts business calculation and accountability, as the profit and loss statement of an enterprise does not reflect reality any more. 

If the purchasing power of money goes down, then it seems that the revenue of the firm is increasing due to the fact that more money is earned. Moreover, the cost of production has been already entered at the amount the enterprise paid for it, but then the purchasing power of money was higher. Accountancy says to the managers that they are having more profits, but these are just a mirage. The costs of the company were calculated with a money of higher value and the revenues were calculated with a money of a lesser value due to inflation ,so they may be actually earning the same as before in real terms, but in nominal terms the revenue is higher.

The resulting profits are overstated and they can affect the decision making of the company in many ways. The enterprise may distribute part of the profits among the shareholders, it may raise wages, reduce selling prices, start new investment plans….    The problem about all this is that, on the grounds that  part or all the registered profits are fake, the company is consuming capital. This is very obvious when we realize that these extra nominal profits are taxed as if they were real ones, such that, after paying taxes, the company is worse off due to the rise in the nominal rate of profit. The distinction between real rates and nominal rates is of outmost importance and it can be better grasped with a numerical illustration extracted from George Reisman’s Capitalism economic treatise ¹.

Imagine that one merchant buys 100$ worth of goods in order to sell them for 110$ later. The 10$ difference is a real rate of profit of 10%. Now the quantity of money increases, inflation is 10% and the merchant sells his goods for 121$. Are profits now 21$ instead of the 10$ prior to the inflation? Yes, but only in nominal terms. Why? Because he is not able to replace next year’s inventory for 100$ anymore, but for 110$. The increased spending volume caused by the higher quantity of money has affected his replacement costs as well as his selling price (both go up 10%). 121$-110$ means a nominal profit of 11$, but remember that inflation was 10%, so his real rate of profit is still 10$; that is, with the 11$ of today he is able to buy the same amount of goods than before with his 10$ of profits. If the merchant realizes the fact that his wealth has remained unchanged, he will keep his spending patterns untouched, BUT the taxing system does not care about that. Imagine a 50% tax rate on nominal profits . During the period prior to inflation, the merchant had a profit of 10$, so he had to pay 5$ in taxes, keeping the remaining 5$ for himself. When his nominal profits rise to 21$ during the inflationary period, he has to pay a tax of 10.5$ and he keeps the rest for himself. Are the remaining 10.5$ real profits? No, not at all. Of the 10.5$ left, 10$ are fully required to replace next year’s inventory, which has a price of 110$ and not of 100$ due to the 10% inflation rate. 10.5$ - 10$ equals 0.50$ of real profits, far less than the 5$ of before. This is the real danger of not differentiating between nominal and real rates, governments tax profits which aren’t actually profits. Thus, companies may be accounting a flood of profits (taking, thereafter, decisions that they wouldn’t have taken otherwise) while actually losing loads of money.

A change in the purchasing power of money also affects debtors and creditors very differently. If a debtor borrows euros or dollars and has to repay the loan in one year, but during this time inflation affects the value of money, he may well be repaying the loan on due date with dollars of lower purchasing power than originally borrowed. There are of course contract clauses that protect creditors from such a circumstance, but ,nonetheless, the future variations in the purchasing power of money cannot be taken into account in the original terms of the credit transaction. In other words, inflation encourages debt and penalizes savings.

Let’s now be more realistic. In today’s monetary system of fiat money and fractional reserve banking, the money supply is under the control of governments, central banks and the banking system. These institutions create new money and inject it into the economy by purchasing goods and services directly or by lending it to favored debtors. The following inflationary process benefits them, the first receivers, at the expense of the latest receivers (or non-receivers). Rothbard says that “In short, monetary inflation is a method by which the government, its controlled banking system, and favored political groups are able to partially expropriate the wealth of other groups in society. Those empowered to control the money supply issue new money to their own economic advantage and at the expense of the remainder of the population.” He then concludes: “Yield to government the monopoly over the issue and supply of money, and government will inflate that supply to its own advantage and to the detriment of the political powerless” ².

Most of the times, tax revenues are not enough to finance the policies of many spendthrift governments. With public sectors’ expenditures topping 50% of GDP, governments have not much room for maneuver when it comes to increase taxes. However, there is another way in which they can divert even more resources from the private sector without any need to resort to taxation. They run deficits that are financed by new money creation coming from the banking system/central bank. It is, so to speak, more sophisticated than printing money directly, which is not considered acceptable anymore, but the consequences are very similar. In both cases, a hidden inflation tax is imposed, among many others, on the relatively fixed income groups in order to benefit the government and its favored debtors and contractors. 

The final comment about inflation is of utmost importance and it is generally the most misunderstood effect of artificial money creation. Very briefly, the Austrian Theory of the Business Cycles tells us that whenever the newly issued money is first used as loans to business, inflation causes the business cycle. Under the fractional-reserve banking system, commercial banks don’t hold 100% of the demand deposits of their customers in reserve. Following a fraudulent practice, they lend part of these demand deposits at a profit, although customers can actually withdraw all the money when they wish to do so, creating therefore new deposits out of the blue (commercial bank money). The Central Bank is a bank of banks that provides commercial banks with liquidity (the CB creates central bank money or “cash” paper money) and “orchestrates” the credit expansion (commercial banks create “commercial bank money” in form of unbacked deposits by expanding credit on top of  their central bank money reserves). Both the central bank and the commercial banks collaborate in a process which actually creates “money”. Note that under this system, “money” is not just cash (central bank money such as dollar bills), but also deposits created by commercial banks, which are not “backed” by real savings but exist in form of accounting entries. The amount of loans that commercial banks are allowed to extend and the easiness in doing it depends on the policies of the Central Bank. 

It follows, then, that new money is issued by the banking system and loaned to businesses. “To businessmen, the new funds seem to be genuine investments, but these funds do not, like free-market investments, arise from voluntary savings. The new money is invested by businessmen un various projects, and paid out to workers and other factors as higher wages and prices. As the new money filters down to the whole economy, the people tend to re-establish their old voluntary consumption/saving proportions. In short, if people wish to save and invest about 20% of their incomes and consume the rest, new bank money loaned to business at fist makes the saving proportion look higher. When the new money seeps down to the public, it re-establishes its old 20-80 proportion, and many investments are now revealed to be wasteful. Liquidation of the wasteful investments of the inflationary boom constitutes the depression phase of the business cycle” ³.  

Quotations, references and comments

¹ George Reisman, Capitalism, a Treatise on Economics, page 229. Published by Jameson Books, Inc (1998).

² Murray N. Rothbard, The Logic of Action One: Method, Money, and the Austrian School, page 312. Published by Edward Elgar Publishing Limited (1997).

³ Murray N. Rothbard, What has government done to out money, pages 55-56. Published by Ludwig von Mises Institute, fifth edition.