Inflation

Before continuing with the fiat system, let us take a historical detour in this chapter to examine the phenomenon of inflation. Inflation is something that almost all mainstream media discuss, yet not everyone understands. Far less well known is the fact that, in its origins, the word inflation did not mean what it means today. The word inflation did not refer to a rise in the price level but to an increase in the quantity of paper money. The first appearances of the word took place during the supposed “free banking” period in the United States (1830—1860), a period in which banks generated large quantities of paper money far in excess of existing gold reserves. The United States Federal Reserve itself documents this fact in a 1997 article on The Origins and Evolution of the Word Inflation[@WordInflation]. Unfortunately, today inflation is synonymous with rising prices, and what is worse, its connection to the quantity of money in circulation is often overlooked.

It is appropriate to say “unfortunately” because the concept of inflation as we understand it today conceals the root of the problem and thereby makes it possible to deceive the vast majority of the population. One could say that the original definition was the first casualty in the theoretical battle over the connection between the increase in the money supply and the general price level. What was once a word describing a cause now describes the consequence of that cause. Although this may seem like an inconsequential semantic matter not worth a moment of our time, it is precisely the opposite. This shift in the definition of a word is in fact a magnificent example of the importance of the meaning of words and of how semantic manipulation can lead us to think incorrectly and to allow those who govern us to make decisions that are not merely mistaken but contrary to ethics.

If this seems exaggerated, consider the following: what would happen if we used the original definition? One thing we can easily observe is that with the original definition the government could not tell us that inflation is caused by greedy corporations, since it is not corporations that manufacture money. It would be very straightforward to know why there is inflation. If there is more money, it is because someone has created it, and the solution to prevent inflation, so defined, would be trivial: that no one be allowed to create new money. Even more, with that definition we would very likely ask ourselves questions such as these:

• Is it ethical for someone to hold a monopoly on the power to create money out of nothing? The rest of us have to work to earn money…

• Given that if any of us creates new money we are sent to prison for counterfeiting, why does there exist “someone” for whom this is not a crime?

• Who is this quasi-divine being with the capacity to create money “legitimately”?

All of these questions would arise naturally if inflation meant the creation of money. With this definition --- the original one --- the solution to avoid inflation would be obvious to everyone, as we noted above: that no one should have the privilege of creating money out of nothing at no cost to themselves. Very simple, and entirely just.

By contrast, if we use the definition most widely in use today --- inflation understood as rising prices --- what is the solution to inflation? Obviously the solution to the problem cannot depend on which definition we use for the word inflation, since the problem remains the same. The solution is the same. Nevertheless, a curious phenomenon occurs: using the current definition, the solution ceases to be obvious. With the current definition it becomes easy to deceive a large part of society. Today we have no choice but to use the term inflation to refer to rising prices, and the question we ask in order to find the cause of inflation (rising prices) is not who creates money but “who raises prices”. The answer to that question is that it is companies that raise the prices of their goods and services. So not only do we mistakenly identify the cause of the problem, but we are also led to mistakenly identify the solution. If the cause of the problem is companies raising prices, then the free market is failing society, and the solution therefore involves the State creating new regulation to set maximum prices in the name of the supposed common good.

In the book Four Thousand Years of Wage and Price Controls by Robert L. Schuettinger and Eamonn F. Butler[@FortyCenturies], one can find countless historical moments in which different governments around the world have taken measures to control prices and wages. All failed. The following passage, taken from that book, perfectly summarises the options available to any government once the money supply has been expanded:

Once the money supply has been expanded, the only choice that can be made is between higher prices or longer queues.

— Robert L. Schuettinger and Eamonn F. Butler

Price control measures always produce the opposite of their intended effect. When a maximum price is set for a given good, it is because the market, if left free, would find a higher price to balance supply and demand for that good. This means that at the regulated price (lower than the free-market price) demand exceeds supply, making it necessary to introduce a mechanism for distributing supply among demand (a quantity greater than what is supplied) according to criteria other than price --- that is, rationing. With this rationing it is the State that decides what share to allocate to each person, and there will inevitably be a portion of demand left unsatisfied.

An additional and even more serious effect is that, by regulating the maximum selling price, the incentive to increase production is completely eliminated, meaning the measure prolongs scarcity over time. By contrast, in a free market, the rise in the price of a given good creates a greater economic incentive to produce that good, leading to a larger supply of it in the medium term, thereby eliminating or at least mitigating the original scarcity. Eliminating free-market price signals always brings consequences opposite to what is supposedly intended. Another side effect of price controls is that excess demand will give rise to a black market for some products, in which that extra demand finds its supply at prices far higher than the regulated ones --- and also higher than those that would have prevailed in the free market, since operating outside the law incurs additional costs.

Despite the fact that economic theory tells us that price controls not only do not work but produce the opposite of the desired effect, and despite the vast number of historical examples over the past 4000 years confirming this reality, price controls continue to be used to this day to a greater or lesser extent.

Ironically, one of the most revealing quotes against price controls comes from one of the greatest advocates of price controls and central planning. In the essay Stand-by Controls[@WritingsofHarper], the American economist Floyd A. Harper mentions an interview conducted by the American economist and writer Henry J. Taylor with Herman Göring, by then a prisoner of war, in 1946:

Your America is doing many things in the economic field which we > found out caused us so much trouble. You are trying to control > people’s wages and prices --- people’s work. If you do that you must > control people’s lives. And no country can do that partially. I tried > it and failed. Nor can any country do it all the way either. I tried > that too and it failed. You are not as good planners as we were. I > should think that your economists should study what happened here.¹

— Herman Göring

But human beings, with rare exceptions, are not good at learning from the mistakes of others; unfortunately we lack that capacity. The vast majority of us need to make the mistakes ourselves in order to learn. This is why today’s proponents of price controls believe they will do it better, and that all the previous failures over 4000 years were, of course, due to those who implemented them doing it poorly --- not because price controls inherently produce the opposite of the desired effect. This fatal conceit, which gives its title to Hayek’s last book[@FatalArrogancia], is what leads humanity to repeat the same collectivist mistakes over and over again.

Inflation is always and everywhere a monetary phenomenon.²

— Milton Friedman

Inflation is simply the readjustment of prices following an increase in the quantity of money in circulation. Since money is created continuously, prices rise continuously. So preventing inflation is trivial --- no complex price regulation law is needed. One simply has to stop creating more money. And since creating money out of nothing is synonymous with stealing, we can also reformulate this by saying that one simply has to stop stealing. This is always the solution to prevent inflation: stop stealing.

Let us look at all of this through a simple thought experiment.

Imagine a small community of ten people on an island who have decided to use as their medium of payment certain warrens, of which there are only 100 units on the entire island. Although the society has very few members, a division of labour has already emerged. One person has specialised in fishing and another in hunting animals. There are a couple of farmers who grow vegetables and gather fruit. There is a kind of carpenter-architect who specialises in building and repairing houses. Another carpenter specialises in building and repairing boats, oars, and other fishing implements. A third person specialises in obtaining the wood that both carpenters need for their work. Clothing is the main activity of another island resident, who has specialised in making the garments needed to stay warm. There are also two cooks who work together. The division of labour and free exchange allow society to prosper and the standard of living to be far better than it would be if a single person lived alone on the island and had to do everything themselves.

The price of one kilogram of potatoes is one warren, and the price of an octopus is generally five warrens. Octopus is scarcer than potatoes, and the free market has determined the price accordingly. Each person freely decides how much time to devote to work depending on what goods they wish to acquire. Some people do not mind eating potatoes, carrots, or fruit every day and having meat or octopus only once a month, in exchange for working no more than four hours a day. Others prefer to eat more meat or fish and do not mind working more hours. Everything is done voluntarily --- both the work and the exchange of goods and services --- and so the ten people live in peace and harmony.

Now imagine that one of the people has the magical ability to create warrens out of nothing. Imagine that “the wizard” creates 100 new warrens. If he kept them in a box at home and never used them, nothing would change --- their effect would go unnoticed. But the wizard has not created the money to leave it in a drawer at home; he begins to use the newly created money to acquire goods and services. Those new 100 warrens enter the island’s economy competing with the existing 100 warrens for the same pool of goods and services. This greater demand for goods has an initial stimulating effect on the economy. The cooks see demand increase for the more expensive dishes --- those based on meat and fish --- causing their prices to rise and orders to increase toward the hunter and the fisherman. These in turn see that there is more demand for meat and fish, find their incomes rising, and raise their prices. Both the cooks and the hunter and fisherman, with their higher incomes, are more willing to spend on other goods --- perhaps to improve their homes or even to save up and build new ones --- which in turn increases demand for the carpenter-architect, who also raises his prices and income. The newly created money, upon entering the economy, raises everyone’s incomes and the prices of everything. At first, not only the wizard but also, to a lesser extent, all the other participants in the economy are experiencing a moment of apparent economic prosperity. But this extra demand for everything pushes prices up until a new equilibrium is reached. After some time, with 200 warrens in the economy instead of 100, twice as many warrens would be needed for the same good as before, and the value of the warrens (their purchasing power) would therefore fall to half. The person who had 10 warrens saved can no longer buy two octopuses --- only one; cannot buy ten kilograms of potatoes --- only five. The effect is the same as if the wizard had stolen 5 of the 10 warrens they had. By creating the new warrens, “the wizard” has stolen 50% of everyone else’s savings, since people can now only buy half as many things as before.

As we saw in the example of the warrens, and even more markedly in a larger economy, this process of price adjustment is not immediate --- quite the contrary: the adjustment takes place gradually throughout the economy as the market discovers the new quantity of money in circulation. This discovery happens indirectly, as the new quantity of money produces an increase in demand for goods and services. Of course, this generalised rise in prices is intertwined with other causes of price variation, such as, for example, a poor maize harvest (which would lead to higher maize prices) or the invention of a new technology that would allow production to increase while reducing costs (which would lead to lower prices).

The variation in the price of a given good as a function of the quantity produced of that good is something we find very easy to understand. If there is a decrease in the production of olive oil, the same demand for a smaller supply pushes the price of oil up. And if there is an excellent harvest and abundant production, the opposite happens. For any good or service, the law of supply and demand is very intuitive and easy to understand.

The law of supply and demand also applies to any currency, but the effect of an increase in the quantity of currency is much harder for us to perceive. This is so mainly for two reasons. On one hand, the creation of money is not a phenomenon that occurs at a single moment but takes place through the expansion of bank credit and is not immediately known data available to everyone. Prices do not adjust immediately because no one knows how much new money exists. As we have seen, it is the market that gradually discovers indirectly that there “must be more money” because there is greater demand. On the other hand, and no less importantly, there neither exists nor can there exist a universal constant by which the value of currency can be measured. Currency is the unit with which we measure the value of other goods, but we have no means of measuring the value of the currency itself. If such a universal constant existed, it would be just as straightforward as for any other good. But the value of things is not objective, and no such universal constant exists. The value of a currency is in reality the set of prices of all other goods and services.

Let us now look at three historical examples from very different eras in which we can verify that rising prices are the direct consequence of an increase in the quantity of money.

The Conquest of the Americas

Following the discovery of the Americas and primarily after the conquests of the Aztec Empire in 1521 and the Inca Empire in 1533, the Spanish seized large quantities of gold and silver --- used by these civilisations mainly as ornaments --- as well as the rich deposits of these metals. The Casa de Contratación, established in Spain in 1502, was responsible for regulating trade with the colonies and organising the fleets that transported goods to and from the Americas, and oversaw the loading of treasures onto ships returning to Spain. During the sixteenth century, approximately two hundred tonnes of gold and around twenty thousand tonnes of silver were sent to Spain, which caused prices that had remained stable for centuries to rise considerably --- first in Spain and then throughout Europe. By the end of the century, prices in Spain had risen by more than 400%. The following passage from the seminal work American Treasure and the Price Revolution in Spain, 1501—1650[@ElTesoroAmericano] by the American historian Earl Jefferson Hamilton, perfectly summarises what happened:

The influx of precious metals from America during the sixteenth > century had a profound and far-reaching effect on the economies of > Europe. The flow of gold and silver arriving in Spain, and from there > to other European countries, caused a marked increase in the money > supply. This expansion of the money supply, without a corresponding > increase in goods and services, gave rise to a sustained rise in > prices known as the Price Revolution.

— Earl Jefferson Hamilton

But one did not have to wait for Hamilton’s work to understand what had occurred. Some people perfectly grasped the cause as early as the sixteenth century, when the price rise was actually happening --- even though the word inflation was centuries away from being coined. In the book Comentario resolutorio de cambios[@ComentarioResolutorio], Martín de Azpilicueta, a professor at the University of Salamanca, wrote the following:

In times when money was scarcer, both goods and labour were exchanged > for far less than after the discovery of the Indies, which flooded the > country with gold and silver.³

— Martín de Azpilicueta

The American War of Independence

In 1775 the Continental Congress, the legislative body governing the Thirteen Colonies prior to the creation of the United States Constitution, urgently needed money to prepare an army and finance the forthcoming war against Britain in anticipation of the imminent declaration of independence. For this reason it decided to begin issuing a form of paper money known as “Continental currency”⁴. These continentals were fiduciary money --- that is, a promise. To understand any fiduciary money, two questions must be answered: who is making the promise, and what are they promising? In this case, a continental was the Congress’s promise to deliver one Spanish dollar⁵ on a specified date. Congress made numerous issues from June 1775 to November 1779, with various redemption dates, totalling approximately 200 million continentals⁶. In 1779, for the first time, and again in 1780, Congress passed retroactive laws altering the redemption dates of the continentals that had been issued. This generated widespread distrust among the people in Congress’s ability to honour its promise, causing the continentals to lose value rapidly. Within six years, prices denominated in continentals had multiplied by 75. During the same period, however, prices in Spanish dollars (silver coins) had not changed significantly --- it was simply that continentals were exchanged at a rate of 75 continentals to 1 Spanish dollar. By 1782 the continentals were already being refused as a form of payment, meaning they had become practically worthless, which gave rise to the popular expression “Not worth a continental”.

In addition to showing that an increase in the quantity of money causes prices to rise, this example illustrates something else: the difference between a real asset (the silver dollar) and an IOU (the promise of a silver dollar). The problem with every IOU is that the party making the promise (generally the State) may not keep it. This “may not keep it” is actually very optimistic. If historical experience is any guide, the probability of a promise being maintained for more than a century is zero. There has never been a banknote in human history for which the original promise was kept for more than a hundred years. And of course no promise has been maintained to the present day, since today all currencies are fiat.

The Weimar Republic

We also have several examples of hyperinflation throughout history that show the phenomena of money creation and rising prices to be intimately linked. One of the most frequently cited is that of the Weimar Republic, the period of German history between 1919 and 1933, the year in which the Nazis came to power. In 1913, one year before the outbreak of the First World War, the German mark stood at 4.2 marks to the dollar. Both Germany and the United States were on the gold standard, so this exchange rate was fixed and was determined simply by the quantities of gold backing one dollar (1.5 grams) and one mark (0.358 grams). Germany abandoned the gold standard on 27 July 1914 as an emergency measure to finance the war. By abandoning the gold standard, the government was free to print as much money as it needed for the war. By the end of the war, ten marks were needed to obtain one dollar. But inflation had only just begun. The Treaty of Versailles, which officially ended the war, imposed severe conditions on Germany: among other things, it was required to disarm and to pay enormous financial reparations to the victorious countries, principally France and England.

One year later twenty marks were needed to buy one dollar, and in 1921, 60. Although this represents a devaluation of more than 90% (inflation of more than 1000%) in seven years --- which is staggering --- it was nothing compared to what was to come over the next two years. Germany continued printing marks to pay its debts, which enormously increased the money supply, or equivalently, devalued the currency. At the beginning of 1922 the mark was trading at 350 marks to the dollar, and by the end of that same year 8000 marks were needed to obtain one dollar. In October 1923 only 1% of government revenue came from tax collection, while the remaining 99% came from printing new marks. It turns out that the new Modern Monetary Theory, MMT, is not as modern as its name suggests, and could very well be called WMT, for Weimar Monetary Theory --- and the economists who propose it ought to read When Money Dies[@WhenMoneyDies] by Adam Fergusson⁷. Continuing with the historical events: on 1 November 1923 a loaf of bread cost 3 billion marks and a pound of meat 36 billion. On 15 November the exchange rate against the dollar reached 4.2 trillion (twelve zeros), and banknotes of 100 trillion marks were already in circulation. From 4.2 marks to the dollar in 1914 to 4.2 trillion marks to the dollar in 1923. By December the German mark had simply ceased to have any value. The value of the notes was proportional to their usefulness as kindling or wallpaper.

To escape that situation, Germany created a new mark, the Rentenmark. How did people come to trust this new mark, after what had been done with the previous one? Was it a prettier colour or printed on better-quality paper? Unlike its predecessor, the new mark was not fiat money that could be printed without limit; instead, it was backed by land. The idea behind the backing of the Rentenmark was to tie the currency to real assets in order to restore confidence and prevent inflation.

As a conclusion to these historical examples, we can observe that in the first of them, the generalised rise in prices was approximately 400% over a century, owing to a roughly proportional increase in the quantity of silver and gold. The increases of 7500% in four years with the continentals of the American War of Independence and the infinite-percent increase of the Weimar Republic are only possible with money backed by nothing --- that is, fiat money. There has never been an episode of hyperinflation in economies where gold formed the basis of money. It is simply not possible, since gold is scarce. A loaf of bread in November 1923 cost 3 billion marks, which, based on the pre-war backing, would have been equivalent to a thousand tonnes of gold. It would be utterly absurd to imagine an economy in which the price of a loaf of bread was a thousand tonnes of gold.

The evidence that the creation of money drives prices up is everywhere: in the very change in the definition of inflation that led us to wrong conclusions, in a multitude of historical episodes, and also in straightforward logical reasoning, since it is nothing other than the law of supply and demand applied to money. Given that the evidence is so overwhelming, it is clear that some reason must exist for a large part of the population not to see this direct connection. It cannot be the product of chance; there is something keeping us “asleep”…

The Consumer Price Index

There is indeed a cause of this widespread drowsiness, and when we think about it, it is quite logical: the “wizard” who holds the power to create money out of nothing. Not only can he create money to live without contributing anything to others --- he can also, at no cost to himself, finance anyone who helps him conceal his deception. With the money he creates he can pay economists who support and propagate the belief in theories arguing that it is in the general interest for the wizard to be able to create money to stimulate the economy when needed, and thereby correct supposed “market failures”. Only in this way can one understand how a completely mistaken theory such as Keynesianism has become the dominant one. Prestigious economists are in reality mere lackeys of the wizard, since the wizard does not pay according to how correct the economist’s theory is, but according to how convenient it is --- that is, how well it justifies his enormous privilege and how effectively it conceals the theft. The incentive for the economist is not to develop an economic theory that describes reality, but to indicate that problems are caused by the free market and that solutions involve giving more power to the wizard. The wizard also finances the belief that the creation of money and rising prices are not directly related, and that the blame for inflation lies with greedy corporations. He ensures that even though all the media talk about inflation, none of them links it to the increase in the quantity of money. The wizard also creates an “indicator” of inflation that can be conveniently manipulated to his advantage so as to yield values far below the actual rate of inflation.

In the countries of Western economies, the State has told us that the target inflation rate is 2%. Nobody performed any calculation to arrive at this figure, no function to be maximised whose result is 2%. We have been persuaded that a little inflation is good for “stimulating” the economy. This is rather surprising once one becomes aware that price inflation is a symptom that a theft has taken place. Surprising and, in a certain sense, dispiriting --- since it is a claim equivalent to “we have been persuaded that a little theft is beneficial for the economy”.

This percentage is the annual increase in an index called the Consumer Price Index, or CPI, which is calculated as a weighted average of the prices of around one thousand products supposedly representative of the entire economy. But this is not a calculation that anyone can carry out independently --- it is one that can be manipulated to yield a result lower than the actual rate of inflation. How does the State achieve this? First, it is the State that decides which goods are included in the basket and which are not. Second, this list can be changed --- and in fact is changed --- when it suits. If a good has risen sharply in price, it can be removed from the list and replaced with one that has not risen as much. Third, the State can also change the weightings, giving more weight to goods that have risen less. In fact, this is a factor where the State does not even need to make an effort to bias the indicator downward. If butter rises by 30% while margarine rises by only 10%, consumers themselves will change their habits. Some butter consumption will be replaced by margarine, and the State can reflect this in new weightings, so that the CPI will vary less than it would if the basket and weightings were fixed.

In addition to the State’s manipulation, there is another factor that causes the CPI to be a downwardly biased measure. People, as consumers, react negatively to having the prices of the products they buy raised, and companies therefore do not want to do so for fear of losing customers. For this reason, some companies try to avoid it through various strategies: for example, instead of raising the price of a yoghurt from 90 cents to one euro, they may choose to make the yoghurt slightly smaller, without it being too noticeable, and raise the price only to 95 cents. In this way the yoghurt appears to have risen by 6%, when in reality it has risen by 15%. And the quantity of product is not the only variable producers can play with to avoid raising the price too much. They can also reduce the quality of the materials or basic ingredients used in order to cut costs rather than increase the price, or to minimise the price increase. This is particularly relevant and concerning in the case of food in general and more specifically of the basic food products that count towards the CPI. In English, this effect is known as shrinkflation --- a word used to refer to the inflation implicit in the shrinking (shrink) of the product rather than in a price increase, a shrinkage that can occur both in the quantity and in the quality of the product sold, as we have discussed.

To close the chapter, one final observation: although inflation is a symptom that a theft has occurred, a given inflation figure expressed as a 2% annual increase in the CPI does not imply that a theft of 2% has taken place. As we have seen, the CPI is heavily biased since it is defined and calculated by those who are doing the stealing. A 2% increase in the CPI may well be the result of a generalised price rise of 5%. But nor would a 2% increase in the CPI mean a theft of 5%. If nothing were being stolen --- that is, if no one created new money out of nothing --- prices would not remain constant but would fall. It is not possible to predict by how much they would fall in a free market, but they would certainly fall, since technological improvement means it becomes progressively cheaper (in terms of working hours) to produce any product. The reason prices rise instead of fall is that the unit with which we measure the value of things (fiat money) shrinks (loses purchasing power) at a rate even faster than the pace of technological progress, except in very specific cases where technological advances are particularly rapid. In summary, and as a final conclusion, we can state that the theft is always greater than the real price inflation, which is in turn always greater than the cooked CPI figure.