Inflation: A Necessary Evil?

In this classic period of deflation (Dec 2008), one must be wondering why I am writing about inflation. But the fact is, as soon as the economy bottoms out, inflation will strike back again. Once again, the purchasing power of the dollar will go down, and people will recall those good old days when gas used to be $1.50.

One wonders how the money is actually getting devalued. Money is supposed to be a store of value—an asset that a human preserves by refraining from immediate consumption. Yet it defies the very definition and loses its value gradually.

The major reason, as any economist in the world would suggest, is an increase in the money supply. The simple logic they refer to is the supply/demand equation. The number of dollars (or any other currency) has increased at a rapid rate compared to other assets whose value is being analyzed. The number of dollars has particularly gone up when we consider the money in the sense of M3 (Physical currency + Checking Accounts + Time deposits + Money Market funds). (For more discussion on money supply, click here.)

But this explanation, to me, is an oversimplification of a complex issue. The fact of the matter is no wealth is created unless we have inflation. Wealth is defined as "anything that has utility and is capable of being appropriated or exchanged." Increase in wealth includes:

1. Any new thing that is useful for humanity

2. Increase in production of existing things to satisfy the needs of a growing population.

Hence, the growth of wealth is necessary for the survival of a growing population as well as to make human life more comfortable.

Let us analyze the role of Central Banks in this increase of wealth. For a moment, let’s assume that Central Banks stop minting (or printing) more money and assume human beings will continue on their mission to increase wealth and population. In such a case, money (dollars) will become scarce compared to total human wealth. The purchasing power of money (dollars) will increase over time, and big investors and the general public alike would want to store their wealth in dollars. Ideal scenario, isn’t it? No! Because this would lead to a lack of investment, resulting in an actual decrease in wealth and disruption of the production cycle. Unemployment would rise, and the standard of living for many people would fall apart.

This is where the Central Bank comes into the picture. They dilute the demand for money (dollars) by printing more of it, leading to a re-establishment of balance between wealth and the number of dollars. This dilution of dollar demand leads investment bankers and the general public to think about preserving their purchasing power by investing their surplus capital into the production system.

Thus, dilution of dollar demand is key to the creation of new wealth. One might wonder: if the job of Central Banks is to establish equilibrium between the number of floating dollars and wealth, then why is the value of individual items (like gasoline) rising? Why is gasoline more expensive now than in 1972 (if the Central Bank is doing what it is supposed to do)?

The answer is:

The number of goods available in 1972 was far fewer than what we have now. Think about all the iPhones/GPhones/Hi-tech computers/Fax machines/Advanced weapons, etc.—we did not have them in 1972. The equilibrium is being established between aggregate wealth and the number of dollars (not between an individual item and the number of dollars). The reason for inflation in individual commodities (like gasoline) is that their rate of growth has been lower compared to the rate of growth of dollars. The reason, as stated above, is the creation of new goods. Had we had the same number of items and the same technology that we had in 1972, then the Central Bank would have increased the money supply in such a way that the cost of each item would have been almost the same.

However, one needs to remember that economics is an inexact field. The Central Bank doesn't have an exact measure of what the wealth of each year is (especially when you include the service sector in wealth computation). So the effect of their dollar-printing activity will have an uneven effect on different commodities/goods.

So, it is unjust for people to blame the Central Bank for inflation, because the creation of new wealth, sustenance of a growing population, and the desire for increased human convenience require the Central Bank to do what it is doing (i.e., printing more dollars and diluting dollar demand). However, this does not mean that Central Banks (Federal Reserves) are perfect organizations; they have many drawbacks, which will be discussed in a separate post.

Some people (especially from the Austrian School of economics) argue that markets take care of themselves. They will themselves establish the equilibrium between the number of dollars and wealth. But the fact of the matter is, it would be very chaotic if the markets were left to bring this equilibrium. The Great Depression of 1928 and the frequent booms/busts before it (in the late 19th and early 20th centuries) clearly show that markets do figure out this equilibrium, but in a very painful way.

Of course, there is one (impractical) way of stopping inflation, and that is:

1. Human beings should stop improving their standard of life.

2. Human beings should stop increasing their population.

Any comments/criticism are welcome.