{"id":4121,"date":"2015-05-07T20:31:31","date_gmt":"2015-05-07T20:31:31","guid":{"rendered":"http:\/\/www.rationalargumentator.com\/index\/?p=4121"},"modified":"2015-05-07T20:31:31","modified_gmt":"2015-05-07T20:31:31","slug":"the-other-half-inflation-story","status":"publish","type":"post","link":"https:\/\/www.rationalargumentator.com\/index\/blog\/2015\/05\/the-other-half-inflation-story\/","title":{"rendered":"The Other Half of the Inflation Story: Credit Expansion Adds Noise to Price Signals – Article by Sanford Ikeda"},"content":{"rendered":"
\n
\"The<\/div>\n<\/div>\n
Sanford Ikeda
\n<\/big><\/big><\/strong><\/span><\/div>\n
May 7, 2015<\/span>
\n<\/big><\/div>\n
******************************<\/div>\n
\n
\n

More money means higher prices. It\u2019s too bad not everyone understands that connection. Even some economists don\u2019t get it. Readers of the Freeman<\/em> do, I\u2019m sure. And they also understand why that\u2019s a bad thing.<\/p>\n

Increasing the supply of money and credit, other things equal, will cause a general rise in wages and prices across an economy. When the Federal Reserve, the central bank of the United States, excessively \u201cprints money,\u201d the result is \u201cinflation\u201d as it\u2019s now commonly called. For those who get the new money after everyone else has spent theirs, inflation means incomes will now buy fewer goods, and every dollar lent before prices rose will be worth less when it\u2019s returned.<\/p>\n

If inflation continues, people will eventually learn to demand more for what they sell and lend in order to compensate for the purchasing power that inflation keeps eating away. That, in turn, will cause prices to rise faster, which makes planning for households and businesses even more difficult. In the past, that difficulty has led to hyperinflation <\/a>and a breakdown of the entire economic system.<\/p>\n

But as awful as all this may be, it\u2019s really only half the story, and perhaps not even the worse half. What follows is a highly simplified story of what happens.<\/p>\n

The structure of production<\/strong><\/p>\n

If you\u2019d like to build a sturdy house, you\u2019ll need to have some kind of blueprint or plan that will tell you two things:<\/p>\n

    \n
  1. how the frame, floor, walls, roof, plumbing, and electrical system will all fit together; and<\/li>\n
  2. the order in which to put these components together.<\/li>\n<\/ol>\n

    Even if the house was made entirely of identical stones, you would need to know how to fit them together to form the floor, walls, chimney, and other structural components. No two stones would serve exactly the same function in the overall plan.<\/p>\n

    The economy is like a house in the sense that each of its parts, which we might call \u201ccapital,\u201d needs to mesh in a certain way if the eventual result will be order and not chaos. But there are two big differences between a house and an economy. The first is that the economy is not only much bigger, but it consists of a multitude of \u201chouses\u201d or private enterprises that have to fit together or coordinate<\/em>, and so it\u2019s an unimaginably more complex phenomenon than even the most elaborate house.<\/p>\n

    The second major difference is that a house is consciously constructed for a purpose, typically for someone to live in it. But an economic system is neither consciously designed by anyone nor intended to fulfill any particular purpose, other than perhaps to enable countless people with plans to do the best they can to achieve success. It\u2019s a spontaneous order<\/em><\/a>.<\/p>\n

    The way all the pieces of capital, from all the diverse people in the economy who own them, fit together is called the capital structure of production<\/em><\/a>.<\/p>\n

    Credit expansion distorts the structure of production<\/strong><\/p>\n

    When people decide to spend a certain portion of their incomes on consumption today, they are at the same time deciding to save some portion for consumption for the future. The amount that they save then gets lent out to borrowers and investors in the market for loanable funds. The rate of interest is the price of making those transactions across time. That is, when you decide to increase your saving, other things equal, the rate of interest (what some economists call the \u201cnatural rate of interest<\/a>\u201d) will fall. The falling interest rate makes borrowing more attractive to producers who invest today to produce more goods in the future.<\/p>\n

    That\u2019s great, because when the market for loanable funds is operating freely without distortions, that means when people who saved today try to consume more in the future, there actually is<\/em> more in the future for them to consume . Businesses today invested more at the lower rates precisely in order to have more to sell in the future when consumers want to buy more.<\/p>\n

    Now, if the Federal Reserve prints more money and that money goes into the loanable funds market, that will also increase the supply of loans and lower the interest rate and induce more borrowing and investment for future output. The difference here is that the supply of loans increases not because people are saving more now in order to consume more in the future, but only because of the credit expansion. That means that in the future, when businesses have more goods to sell, consumers won\u2019t be able to buy them (because they didn\u2019t save enough to do so) at prices that will cover all of the businesses\u2019 costs. Prices will have to drop in order for markets to clear. Sellers suffer losses and workers lose their jobs.<\/p>\n

    And, oh yes, all that credit expansion also causes inflation.<\/p>\n

    While this process sounds rather involved, it\u2019s still a highly simplified version of what has come to be known as the Austrian business cycle theory. (For a more advanced version,\u00a0see here<\/a>.) Of course, each instance in reality is significantly different from any other, but the narrative is essentially the same: credit expansion distorts the structure of production, and resources eventually become unemployed.<\/p>\n

    The explanation is more involved than the typical inflation-is-bad story that we\u2019re more familiar with. Indeed, that probably explains why it\u2019s the less-well-known half of the story. Even Milton Friedman and the monetarists<\/a> pay little attention to the capital structure, choosing instead to focus on the problems of inflationary expectations.<\/p>\n

    Again, for Austrians, the problem arises when credit expansion artificially lowers interest rates and sets off an unsustainable \u201cboom\u201d; the solution is when the structure of production comes back into alignment with people\u2019s actual preferences for consumption and saving, which is the \u201cbust.\u201d Most modern macroeconomists see it exactly the opposite way: the bust is the problem, and the boom is the solution.<\/p>\n

    An intricate, dynamic jigsaw puzzle<\/strong><\/p>\n

    To close, I\u2019d like to use an analogy I learned from Steve Horwitz (whom I heartily welcome back as a fellow columnist here at the Freeman<\/em>).<\/p>\n

    The market economy is like a giant jigsaw puzzle in which each piece represents a unique unit of capital. When the system is allowed to operate without government intervention, the profit-and-loss motive tends to bring the pieces together in a complementary way to form a harmonious mosaic (although in a dynamic world, it couldn\u2019t achieve perfection).<\/p>\n

    Credit expansion, then, is like someone coming along and making too many of some pieces and too few of others \u2014 and then, during the boom, trying to force them together, severely distorting the overall picture. During the bust, people realize they have to get rid of some pieces and try to discover where the others actually fit. That requires challenging adjustments and may take some time to accomplish. But if the government tries to \u201chelp\u201d by stimulating the creation of more superfluous pieces, it will only confuse matters and make the process of adjustment take that much longer.<\/p>\n

    Inflation is bad enough. Unfortunately, it\u2019s only half the story.<\/p>\n

    Sanford Ikeda is a professor of economics at Purchase College, SUNY, and the author of The Dynamics of the Mixed Economy: Toward a Theory of Interventionism<\/em>.<\/strong><\/p>\n

    This article was originally published by The Foundation for Economic Education<\/a>.<\/strong><\/p>\n<\/div>\n<\/div>\n","protected":false},"excerpt":{"rendered":"

    Sanford Ikeda May 7, 2015 ****************************** More money means higher prices. It\u2019s too bad not everyone understands that connection. Even some economists don\u2019t get it. Readers of the Freeman do, I\u2019m sure. And they also understand why that\u2019s a bad thing. Increasing the supply of money and credit, other things equal, will cause a general rise in wages and prices across an economy. When the Federal Reserve, the central bank of the United States, excessively \u201cprints money,\u201d the result is…<\/p>\n

    Read More Read More<\/span><\/a><\/p>\n","protected":false},"author":3,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"footnotes":""},"categories":[419,7],"tags":[641,1018,339,234,2664,2665,227,4080,236,506,686,899],"class_list":["post-4121","post","type-post","status-publish","format-standard","hentry","category-business-2","category-economics","tag-austrian-economics","tag-banking","tag-fed","tag-federal-reserve","tag-fee","tag-foundation-for-economic-education","tag-free-market","tag-government-intervention","tag-inflation","tag-interventionism","tag-money","tag-sanford-ikeda"],"_links":{"self":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts\/4121","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/users\/3"}],"replies":[{"embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/comments?post=4121"}],"version-history":[{"count":1,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts\/4121\/revisions"}],"predecessor-version":[{"id":4122,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/posts\/4121\/revisions\/4122"}],"wp:attachment":[{"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/media?parent=4121"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/categories?post=4121"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/www.rationalargumentator.com\/index\/wp-json\/wp\/v2\/tags?post=4121"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}