Why Is Inflation So Bad?

[ad]A cornerstone of government economic policy is to “fight” inflation and make sure we do not have too much of this problem, to make sure we minimize the costs of inflation. This is in a sense why we are taught there is a need for the Federal Reserve: they manage the currency and interest rates in such a way that inflation is kept at a minimum. This is an important task, and that is why the news media so frequently reports on inflation and talks of “inflationary” policies, etc.

But why is inflation a problem? According to the common definition used in the media, in politics, as well as in economics, inflation is an “increase in the price level of goods and services.” It is therefore pretty obvious why inflation is bad for most of us: with higher prices we get less for our hard earned dollars. Indeed, the latter is sometimes made part of the definition: “prices for consumer goods rise, eroding purchasing power” (emph. added).

So we, i.e., all of us, would definitely have an interest in keeping inflation “as low as possible,” or – even better – at zero (if possible). In other words, we should be grateful that we have government and the Federal Reserve to protect us and the economy from inflation, which would make us a lot poorer were it allowed to increase.

It is a well known fact that prices tend to increase. Ask anyone and they know for sure that prices will go up, which makes it better to buy whatever you need now, if you have the funds necessary, rather than wait for later. Especially if you are not sure how much your salary will increase (if at all). In other words, those of us who do have funds could very well become richer through spending than holding on to their money.

So there seems to be a bias in the economy to increase differences in wealth. Those who already have enough funds don’t have to wait for higher prices, and thus get more for their dollars than those of us who don’t have that much money. In other words: if you are rich, you will get richer; if you are poor, you will stay poor.

This is the problem with the capitalist economic system, if you ask any Marxist economist or theorist. The economic system does not only distribute wealth unevenly, it also augments the differences; this is the very basis for exploitation – the rich industrialists are given the opportunity by both the state and the economy to make more money, to get even wealthier, while the poor labor workers’ salaries are literally swallowed by inflation.

And it is conventional wisdom that prices do indeed always go up. Prices of groceries and clothing go up; prices for energy go up; prices for houses as well as rented apartments go up; prices of cars, transportation, and travel go up; prices for health care and education go up. Up, up, up. They don’t ever go down, at least not in the long run. Or do they?

Let’s have a look at an example of a free market, without regulation, and what would happen to prices. Imagine there is a market for goods and that it is at equilibrium (or close to it), so that demand is approximately the same as supply. In other words, prices are set at such a level that there isn’t a great shortage (demand higher than supply) or surplus (supply higher than demand). In other words, the market “works.”

In this market, if relative demand suddenly goes up the prices will follow (upwards). This would also be true if relative supply goes up, which would lead to prices going down to adjust for the increased number of goods in the market that would not be sold if the price was not lowered. Prices may be different in different areas, but the market as a whole (at any level) is somewhat stable in that it “tries” to approach equilibrium. There will thus not be a long time period of constant surplus or shortage; such inefficiencies will be corrected through price changes.

But let us make something clear: such price changes are not the same as constanly increasing (or decreasing) prices. We haven’t gotten that far in the example yet. So far, all we know is that prices fluctuate naturally in a market.

What happens over time? One thing that is for sure is that producers have a great incentive to be efficient, or more importantly: to increase efficiency. Increased efficiency means the products can be offered in the market to a lower price than competitors are able to match, which means increased market share and thus (hopefully) increased profits. Such increased efficiency, which is caused by constant market competition (from existent competitors or probable future such), is largely the same as economic growth.

There should thus be a tendency in the market for these products towards lower prices. Of course, if prices for energy, capital goods, and labor go up, prices might not go down as much. But as long as there are markets for energy and capital goods the prices in these markets would tend to go down as well.

If we assume salaries are kept at a constant level, the purchasing power of each dollar earned would increase. This should mean any consumer with income or funds at hand would be better off waiting for lower prices rather than to purchase the goods immediately. In other words, there is a fundamental market incentive for saving rather than spending, which in turn should put extra pressure on producers and sellers of goods and services to “make” consumers purchase as soon as possible (and therefore also increased competition).

At this point (or sooner), the Marxist would definitely ask about the market for labor – wouldn’t it too tend towards lower prices and thus lower salaries? Well, so far we have only discussed the supply side, companies supply the market with goods and services. These companies are however not suppliers of labor – they are consumers of labor, and therefore companies employing labor workers would bid prices up rather than down. The supply side competes and thereby push salaries down; in this case, labor workers themselves would, through competing for the best employment available, push salaries down. Would labor workers compete to such degree that they would not only accept, but compete for, exploitation level salaries?

In a free market, which is the fundamental assumption in this example, there are no regulations restricting the market in such a way that labor workers are forced to accept employment. Companies compete for labor workers not only with other companies, but also with the possibility of labor workers starting their own businesses (individually or together), making use of their competencies and reaping the full profits. It is very unlikely that a freed market would tend towards a situation where a whole class (if such a thing at all exists in a market) would choose slave labor or exploitative employment.

If this is indeed true, you might ask why not the market for capital goods work the same way – companies are consumers of capital goods. This is true, and I have so far only discussed the supply side of this; there is also a demand side for capital goods competing for consumption in such a way that prices are bid up.

But it is important to understand that a new type of capital good (like a machine), used by an entrepreneur seeking new and more efficient ways of producing some good, is expensive at first – but as soon as the market realizes that there are profits to be earned from adopting the same type of capital goods in production, the market grows and the market therefore generates incentives for increasing efficiency in producing the capital good itself.

(The same is true in the labor market, where unique knowledge in a new market is highly rewarded, whereas relative salaries may go down as this knowledge becomes a common characteristic sought for in the market.)

What we have in such a market is therefore deflation rather than inflation, at least if we assume there is no secret meddling with the currency itself. If the currency used in the market place is stable, actors in the market will see the value of each dollar measured in goods and services go up. In other words: prices go down.

If the market works in such a way that a stable currency is effectively deflated, then the cause of inflation in our contemporary markets must be something other than the market itself. As we have already established, prices do tend to go up and the value of one’s salary, measured in the amount of goods and services it can purchase, is constantly abated.

To understand the inflation from which we suffer, we need first ask: 1. why do prices go up rather than down? and 2. is the currency stable?

The first question can be answered rather easily without having to study the market or the details of it. In our example we assumed a free market without regulation, whereas the real market today is extensively regulated by [at least] three levels of government. The market mechanisms are restricted (if at all allowed) and therefore the market does not function as a market. In other words, the regulated market may not deliver the positive effects expected.

The second question can as easily be answered. No contemporary currencies are stable, partly because they are not fixed in value (through for instance an exchange value set in commodities) and partly because the money supply is constantly increased. In other words: the value of money is based thoroughly on expectations that it will be accepted by sellers of goods and services in the future and that it will retain some or all of its value; and the volume of currency notes (bills and coins) is increased relative to the market estimate of number of products and services already available, which causes a pressure on prices upward. The supply of money without backing in “real” value is in other words increased, while the market has not created a corresponding increase in available goods and services.

Inflation according to the mainstream definition is therefore a product of government-imposed restrictions on how the market functions, while government at the same time is supplying a currency without a real value base that is constantly suffering from an [artificial] increase in supply. The reason inflation is such a problem is thus that the market is not allowed to generate wealth through economic growth to the degree (or even fraction of) it would if left unregulated, and that government is constantly devaluing the currency the market uses. No wonder inflation is a problem – we are getting poorer from not reaping the full profits of our investments (in terms of money, labor, effort, and ideas) while being stripped of the value we have at hand (as currency).

And then government comes to the rescue claiming to fight inflation?