Monetary Inflation Won’t Create Economic Growth

When it comes to matters of money and banking, all practical political issues ultimately hinge on one central question: can one improve or deteriorate the state of an economy by increasing or decreasing the quantity of money?1

Aristotle said that money was no part of the wealth of a nation because it was simply a medium of exchange in inter-regional trade, and the authority of his opinion thoroughly marked medieval thought on money. Scholastic scholars therefore spent no time enquiring about the benefits that changes of the money supply could have for the economy. The relevant issue in their eyes was the legitimacy of debasements, because they saw that this was an important issue of distributive justice.2 And after the birth of economic science in the 18th century, the classical economists too did not deny this essential point. David Hume, Adam Smith, and Étienne de Condillac observed that money is neither a consumers’ good nor a producers’ good and that, therefore, its quantity is irrelevant for the wealth of a nation.3 This crucial insight would also inspire the intellectual battles of the next four or five generations of economists—men such as Jean-Baptiste Say, David Ricardo, John Stuart Mill, Frédéric Bastiat, and Carl Menger—who constantly made the case for sound money.

As a result, the Western world had much more sound money in the 19th century than in the 20th century. Large strata of the population paid and were paid in coins made out of precious metals, especially out of gold and silver. It was money that made these citizens, however humble their social status, sovereign in monetary affairs. The art of coinage flourished and produced coins that could be authenticated by every market participant.

Some present-day libertarians harbor a romantic picture of these days of the classical gold standard. And it is true that it was the golden age of monetary institutions in the West, especially when we compare them with our own time, in which the monetary equivalent of alchemy has risen to the status of orthodoxy. But it is also true that western monetary institutions in the era of the classical gold standard were far from being perfect. Governments still enjoyed monopoly power in the field of coinage, a remnant of the medieval regalia privileges that prevented the discovery of better coins and coin systems through entrepreneurial competition. Governments frequently intervened in the production of money through price-control schemes, which they camouflaged with the pompous name of bimetallism. They actively promoted fractional-reserve banking, which promised ever-new funds for the public treasury. And they promoted the emergence of central banking through special monopoly charters for a few privileged banks. The overall result of these laws was to facilitate the introduction of inflationary paper currencies and to drive specie out of circulation. At the beginning of the 19th century, most of Europe, insofar as it knew monetary exchange at all, used paper currencies.4 And during the remainder of that century, things did not change much. England alone among the major nations was on the gold standard during the greater part of the 19th century, and banknotes of the Bank of England played a much greater role in monetary exchanges than specie—in fact, the reserve ratio of the Bank seems to have been around 3 percent for most of the time, and occasionally it was even lower.5

In short, the monetary constitutions of the 19th century were not perfect, and neither would the monetary thought of the classical economists satisfy us today.6 David Hume believed that inflation could stimulate production in the short run. Adam Smith believed that inflation in the form of credit expansion was beneficial if it was backed up with a corresponding amount of real goods, and Jean-Baptiste Say similarly endorsed expansions of the quantity of money that accommodated the needs of commerce. Smith and Ricardo suggested increasing the wealth of the nation by substituting inherently valueless paper tickets for metallic money. John Stuart Mill championed the notion that sound money means money of stable value. These errors in the monetary thought of Hume, Smith, Ricardo, and Mill were of course almost negligible in comparison to their central insight, to repeat, that the wealth of a nation does not depend on changes in the quantity of money. But eventually a new generation of students, infected with the virus of statism—worship of the state—brushed over that central insight, and thus the errors of the classical economists, rather than their science, triumphed in the 20th century.

Men such as Irving Fisher, Knut Wicksell, Karl Helfferich, Friedrich Bendixen, Gustav Cassel, and especially John Maynard Keynes set out on a relentless campaign against the gold standard. These champions of inflation conceded the insight of the classical economists that the wealth of a nation did not depend on its money supply, but they argued that this was true only in the long run. In the short run, the printing press could work wonders. It could reduce unemployment and stimulate production and economic growth.

Who could reject such a horn of plenty? And why? Most economists point out the costs of inflation in terms of loss of purchasing power—estimates run as high as a 98 percent reduction of the US dollar’s purchasing power since the Federal Reserve took control of the money supply. What is less well known are the concomitant effects of the century-long great dollar inflation. Paper money has produced several great crises, each of which turned out to be more severe than the preceding one. Moreover, paper money has completely transformed the financial structure of the western economies. At the beginning of the 20th century, most firms and industrial corporations were financed out of their revenues, and banks and other financial intermediaries played only a subordinate role. Today, the picture has been reversed, and the most fundamental reason for this reversal is paper money. Paper money has caused an unprecedented increase of debt on all levels: government, corporate, and individual. It has financed the growth of the state on all levels, federal, state, and local. It thus has become the technical foundation for the totalitarian menace of our day.

In the light of these long-term consequences of inflation, its alleged short-run benefits lose much of their attractiveness. But the great irony is that even these short-run benefits in terms of employment and growth are illusory. Sober reflection shows that there are no systematic short-run benefits of inflation at all. In other words, whatever benefits might result from inflation are largely the accidental result of inflation hitting a particularly favorable set of circumstances, and we have no reason to assume that these accidental benefits are more likely to occur than accidental harm—quite to the contrary! The main impact of inflation is to bring about a redistribution of resources. There are therefore short-run benefits for certain members of society, but these benefits are balanced by short-run losses for other citizens.

The great French economist Frédéric Bastiat made the quite general point that the visible blessings that result from government intervention into the market economy are in fact only one set of consequences that follow from this intervention. But there is another set of consequences that the government does not like to talk about because they demonstrate the futility of the intervention. When the government taxes its citizens to give subsidies to a steel producer, the benefits to the steel firm, its employees, and stockholders are patent. But other interests have suffered from the intervention. In particular, the taxpayers have less money to patronize other businesses. And these other businesses and their customers are also harmed by the policy because the steel firm is now able to pay higher wages and higher rents, thus bidding away the factors of production that are also needed in other branches of industry.

And so it is with inflation. There is absolutely no reason why an increase in the quantity of money should create more rather than less growth. It is true that the firms who receive money fresh from the printing press are thereby benefited. But other firms are harmed by the very same fact because they can no longer pay the higher prices for wages and rents that the privileged firm can now pay. And all other owners of money, whether they are entrepreneurs or workers, are harmed too, because their money now has a lower purchasing power than it would otherwise have had.

Similarly, there is no reason why inflation should ever reduce rather than increase unemployment. People become unemployed or remain unemployed when they do not wish to work, or if they are forcibly prevented from working for the wage rate an employer is willing to pay. Inflation does not change this fact. What inflation does is to reduce the purchasing power of each money unit. If the workers anticipate these effects, they will ask for higher nominal wages as a compensation for the loss of purchasing power. In this case, inflation has no effect on unemployment. Quite to the contrary, it can even have negative effects, namely, if the workers overestimate the inflation-induced reduction of their real wages and thus ask for wage-rate increases that bring about even more unemployment. Only if they do not know that the quantity of money has been increased to lure them into business at current wage rates will they consent to work rather than remaining unemployed. All plans to reduce unemployment through inflation therefore boil down to fooling the workers—a childish strategy, to say the least.7

For the same reason, inflation is no remedy for the problem of sticky wages—that is, for the problem of coercive labor unions. Wages are sticky only to the extent that the workers choose not to work. But the crucial question is, how long can they afford not to work? And the answer to this question is that this period is constrained within the very narrow limits of their savings. As soon as a worker’s personal savings are exhausted, he willy-nilly starts offering his services even at lower wage rates. It follows that in a free labor market, wages are sufficiently flexible at any point of time. Stickiness comes into play only as a result of government intervention, in particular in the form of (a) tax-financed unemployment relief and of (b) legislation giving the labor unions a monopoly of the labor supply.

Since we are not concerned here with questions of labor economics, we can directly turn to the connection between employment and monetary policy. Does inflation solve the problem of sticky wages? The answer is in the negative, and for the same reasons we pointed out above. Inflation can overcome the problem of sticky wages only to the extent that the paper-money producers can surprise the labor unions. To the extent that the latter anticipate the moves of the masters of the printing press, inflation will either not reduce unemployment at all, or even increase it further.8

[Adapted from Part II of the essay “Deflation and Liberty.”] 

1. Speaking of an economy we mean the group of persons using the same money. Our analysis therefore concerns both open and closed economies in the usual connotations of the terms, which relates closedness and openness to political borders separating different groups of persons.
2. See Aristotle, Politics, book 2, chap. 9; Nicomachian Ethics, book V, in particular chap. 11; Nicolas Oresme, Traité sur l’origine, la nature, le droit et les mutations des monnaies, Traité des monnaies et autres écrits monétaires du XIV siécle, Claude Dupuy, ed. (Lyon: La Manufacture, 1989); Juan de Mariana, A Treatise on the Alteration of Money, Markets and Morality 5, no. 2 ([1609] 2002).
3. See David Hume, “On Money,” Essays (Indianapolis: Liberty Fund, [1752] 1985), p. 288; Adam Smith, Wealth of Nations (New York: Random House, [1776] 1994), book 2, chap. 2, in part. pp. 316f.; Condillac, Le commerce et le gouvernement. 2nd ed. (Paris: Letellier & Maradan, 1795), in part. p. 86; translated as Commerce and Government (Cheltenham, U.K.: Elgar, 1997).
4.  At the time John Wheatley observed, “In England, Scotland, and Ireland, in Denmark, and in Austria, scarcely any thing but paper is visible. In Spain, Portugal, Prussia, Sweden, and European Russia, paper has a decisive superiority. And in France, Italy, and Turkey only, the prevalence of specie is apparent.” (An Essay on the Theory of Money and Principles of Commerce, p. 287).
5. See Jacob Viner, “International Aspects of the Gold Standard,” Gold and Monetary Stabilization, Quincy Wright, ed. (Chicago, Chicago University Press, 1932), pp. 5, 12. Viner emphasizes that the pre–World War I gold standard was not fundamentally different from the interwar gold-exchange standard. It was a managed standard (p. 17). This attenuates the thesis of Jacques Rueff that the gold-exchange standard introduced something like a quantum-leap deterioration into the international monetary system. See Rueff, The Monetary Sin of the West (New York: Macmillan, 1972).
6. For a recent essay criticizing some of the main fallacies of classical monetary thought, see Nikolay Gertchev, “The Case For Gold—Review Essay,” Quarterly Journal of Austrian Economics 6, no. 4 (2003).
7. See in particular Mises, Die Ursachen der Wirtschaftskrise (Tübingen: Mohr, 1931); translated as “The Causes of the Economic Crisis,” in On the Manipulation of Money and Credit (Dobbs Ferry, N.Y.: Free Market Books, 1978). See also Mises, “Wages, Unemployment, and Inflation,” Christian Economics 4 (March 1958); reprinted in Mises, Planning For Freedom, 4th ed. (South Holland, Ill.: Libertarian Press, 1974), pp. 150ff. The long-standing presence of mass unemployment in Germany, France, and other European countries seems to be a smashing refutation of the Keynesian hypothesis. If anything, the labor unions in these countries clearly seem to overestimate the inflation rate.
8. On the entire issue see in particular William Harold Hutt, The Theory of Collective Bargaining (San Francisco: Cato Institute, [1954] 1980); idem, The Strike-Threat System (New Rochelle, N.Y.: Arlington House, 1973); idem, The Keynesian Episode (Indianapolis: Liberty Press, 1979).