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In Theory

Economists and politicians understand full well what inflation is and how it works, but they have two different justifications for it. For politicians it is quite easy; inflation simply means new money they can use to purchase votes. For economists, it is the correct approach to take to prevent busts when economies begin to slow down.

As we have previously written quite extensively, inflation is simply new printed money chasing the same amount of goods. There is no mystery here. The mystery is actually manufactured by economists, particularly Keynesians and Monetarists. The reason is simple, if you would fully understand how you are being conned, you would be quite upset… which is the last thing politicians (economists’ masters) want. Upset people do not vote for upsetting politicians.

To see how this works, let’s assume that in a country, the total amount of money in circulation is 100.000 morlocks (yes, morlocks are a very valuable currency). The economy is slowing down and politicians are worried they will lose votes. So, they summon their central bank economists and they order them to create 10,000 morlocks which they plan to spend on “stimulus” (i.e. purchases that will spur economic activity). At the same time, this new money will lower interest rates which will further “entice” businesses to invest.

So, through the magic of the fractional reserve system, central bank economists create 10,000 morlocks from thin air. They pass this money to politicians who promptly spend it. As companies selling to the government receive this money, they in turn order more supplies to replenish their inventories, and the same thing happens to the suppliers with their suppliers and so on. Result? Economic activity is restarted. Furthermore, since now interest rates are low, businesses find it attractive to invest longer term because they will now have higher profits and the new-and-improved economic conditions will ensure sales. So they borrow and spend which further increases economic activity.

Of course, now we have 110,000 morlocks in circulation, but who cares since economic activity is going up and everybody is happy. It is true that now everything will cost 10% more, but this is a small price to pay for prosperity.

 Inflationary Taxation


In Reality

For as long as the economy is more-or-less operating within “normal” conditions, it can be stimulated as it was explained above. However, what happens when the “stimulus” wears off?

Let’s continue where we left. The government has just spent 10,000 morlocks and the economy is reactivating. Businesses had replenished inventories and expanded and then…. nothing happens. The original 10,000 morlocks have been spent. There are no new buyers. It was all an illusion. Furthermore, now that money is worth 10% less, interest rates are going up. Indebted business have no sales and huge debts. They go bust. People gets fired. The economy crashes. Voila! We have a bust.

To prevent this, the government calls their economic minions to “make” them another 10,000 morlocks to “stimulate” the economy and… the cycle begins again. The only difference, is that now we have 120,000 morlocks in circulation. This means that things are now 20% more expensive than at the beginning.

In other words, we have just lost 20% of the value of our savings. This drop of 20% is real. You can buy only 80% of what you could buy before inflation started. Because of this effect, it makes no difference if inflation ate 20% of your savings or the government robbed you 20% through taxation. In the end, you are 20% poorer.

But why do we call inflation a tax? Because that extra 20% is taken from your pocket and given to the government to spend. Yes, the process is convoluted, complex, complicated and does not happen instantaneously, but the net effect is the same. Politicians are stealing your money to keep themselves (and their favorites) in power and wealthy.

It gets worse. The creation of this “new” money is instantaneous. A few bureaucrats punch a few numbers in a computer and we are done! 10,000 new shiny digital morlocks have been created. The government the proceeds to spend this money in “stimulus” programs. And who get’s this money? Friends of the government, of course! When these friends get their money, the rest of the population is unaware of the fact that 10,000 new morlocks were created. They still operate under the assumption that the total amount of morlocks is 100,000. So, they sell goods and services to those “friends of the government” at old prices. By the time the new morlocks reach the population and they become aware of the grand total (110,000) it’s too late. They lost money in the sales.

This can be better understood if one realizes that money is simply a means of exchange. Consider this. A cup of coffee costs 1 morlock. A loaf of bread costs 1 morlock. In total, there are only 10 morlocks in circulation in the economy. This means that in terms of value, a cup of coffee equals a loaf of bread and they equal 10% of all morlocks in circulation (1 divided by 10). If we would ignore money for a second and go back to bartering, we would be able to exchange a cup of coffee for a loaf of bread. We would be able to do this yesterday, today and tomorrow because the value of those two items do not change.

Let’s now say that I create 4 new morlocks out of thin air. I just printed them and told nobody. I give those 4 morlocks to my friend. With them, he goes and purchases one cup of coffee. The coffee seller is delighted… until he realizes that, strangely enough, where there used to be a grand total of 10 morlocks, now we have 11!! He does a rapid calculation and realizes that he just sold a cup of coffee for roughly 9% of all circulating morlocks (1 divided by 11) instead 10% (he lost 1%). This upsets him but then he then realizes that all he needs to do is to raise the price of a cup of coffee. He wants to get 10% of all circulating morlocks and so 10% of 11 it 1.1 morlocks. My firend visits the coffee seller again, and buys another cup of coffee with his “new” money. He now pays 1.1 morlocks. However, the coffee owner soon realizes what happened and rises its prices accordingly to 10% of 12.1, which is roughly 1.2 morlock per cup or coffee.

But the bread maker does not know any of this. He still believes that the total amount of morlocks is 10. So, when the coffee seller buys two loafs of bread, he purchases them at the old price of 2 morlocks (1 morlock each). These two morlocks now represent only roughly 16% of the total amount of morlocks (2 divided by 12.1) or 8% per loaf. Let’s now tabulate the losses:

Me: I created morlocks out of thin air, so I have no losses, only profits.

My friend: he was given the morlocks, so he had no losses, only gains.

The coffee seller: 1% for the first cup and 1% for the second. Total loss = 2%

The bread maker: 2% per loaf of bread. Total loss = 4%

What this means is that through the magic of inflation, the government is getting “free money” which it spends as “real” money. The first person selling a product to the government has some loses but they are not so bad. However, the person selling to the first seller incurs in much larger loses. In a complex economy this process can have a large number of links in this chain and be much, much more convoluted, but the result is always the same.

The government gets free money and the closer your sale is to this source, the less money you lose. Unfortunately, the last link in the chain is the consumer. This means that the consumer is the one sustaining the largest loses. It is for this reason that inflation is considered regressive to a certain degree, because the lower your income, the farther away you are from the source of new money and therefore the larger your loss.

In summary, thanks to the wonders of the fractional reserve system, we have inflation which creates booms and busts. Inflation, let’s remember, was created to eliminate those very same booms and busts it is generating now! In addition, we have inflation which robs you of your after-tax money with a hidden tax. And then, adding insult to injury, we find that the poorest people, the ones on fixed incomes or savers are hit the hardest!

Do we need to say more?

Note: please see the Glossary if you are unfamiliar with certain words.

Continue to Taxes And Myths - Part 7


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