Many economists fail to understand that money is not "neutral." Changes in the supply of money, or it the demand for it, do have major economic consequences; they do not merely lead to a higher or lower price level, but also to misallocations of capital and economic depressions.

The Biggest Economic Myth of Our Time

The annual loss of purchasing power of our money is not a natural phenomenon, it’s a policy choice. It certainly is not 'normal' that our money is losing several percent of its worth each year.

But although this annual loss of value is bad enough, it is not the biggest problem related to inflation. The real trouble is that it’s impossible for the prices of all goods and services in the economy to rise to the same extent at the very same time.

For the price level to rise uniformly, our Money Master — Fed chairwoman Yanet Yellen in the United States — would have to give an equal amount of dollars to all citizens which they would have to spend at exactly the same moment.

But in the real world, newly created money is not distributed equally among the citizens; it is added to someone’s checking account instead. This newly created money enters the economy as soon as this person spends it. Price elsewhere in the economy will only rise at a later point in time; when the recipients of that money decide to spend it. This process continues until the prices of all goods and services in the economy are adjusted to the new money supply.

In other words, inflation is a process.

Inflation is not like a water surface level that rises or drops uniformly. Rather, it is like a bottle of syrup that is squeezed and then slowly spreads out on the table.

In a Market Economy, the Consumers Are the Ones Who Dictate

The question in economics is how to allocate the available scarce resources — like raw materials, labor and time —in the most efficient way to satisfy everyone’s needs.

In a market economy, the consumers are the ones who dictate. By spending money on some products and services, and by not spending it on other goods and services, consumers guide the actions of capitalists and entrepreneurs. The capitalists and entrepreneurs who succeed best in serving the consumers are the ones who make profits, the others suffer losses.

A market economy — or capitalism — is the only economic system that gears production towards consumer preferences.

Inflation Is a Breach on Consumer Sovereignty

By buying and abstaining from buying, consumers decide what, how, and how much is to be produced and by whom. Consumer preferences are communicated via the price mechanism. Prices — and the corresponding profits and losses — tell capitalists and entrepreneurs how consumers want to see them use the available scarce resources.

As mentioned before, (relative) prices are distorted by the inflation, and therewith, the allocation of the resources that businesses own.

Suppose new and additional money enters the economy because bank A grants a loan to businessman B who subsequently spends it. The result is higher prices in the industry where the money was spent. The monetary demand in one part of the economy has increased, thereby raising the profitability of that industry. This increased profitability leads to a temporary imbalance; more money is invested in this industry, despite the fact that consumer preferences are unchanged.

Relative prices are restored eventually, when the inflation has run its course. The unprofitability of the investments in businessman B’s industry is revealed when other prices equally start to rise, reflecting the change in the money supply.

A Recession Is Not the Problem, But the Solution

In other words, inflation (and deflation) — defined as changes in the demand for, and supply of, money — leads to economic recessions. In our real economy, the process described above takes place on a billion dollar scale, where central banks are consciously aiming at causing inflation without understanding that they are simultaneously causing recessions.

Central banks are like pyromaniac firefighters.

They set the building on fire and subsequently pretend to come to the rescue. TIME Magazine even used the headline "The committee to save the world" on their front page to describe the board of the U.S. central bank, the Federal Reserve.

After reading this, you may come to understand that recessions are not the problem, but the solution. Relative prices — reflecting the real consumer preferences — are restored during a recession. Demand and supply are no longer 'distorted' by changes in the money supply.

Most of the Inflation Enters the Economy via the Loan Market

But the problems don’t end here. The new and additional deposit currency (in reality, a debt instrument that is 'as good as money') enters the economy via the loan market.

The interest rate is the first price to be affected.

The problem is that the interest rate is a key variable in the valuation of corporate assets, since all future cash flows, discounted to their present value, are suddenly worth a lot more than previously. This phenomenon is called 'the time value of money' by accountants.

The interest rate is one of the most important prices in an economy, and currently the most manipulated one.

More Distress is Inevitable

After the '08 financial crisis, I wrote regularly about the causes of the recession. I remarked that in absence of a monetary reform the same story would inevitably repeat itself, and that after five or six years I would be giving the very same seminars that I was giving at that time.

And a recurrence of '08 — the biggest economic recession since the Great Depression — is likely to be worse, not better. The reason is that our pyromaniac firefighter is taking his job a little bit too seriously. Never before have interest rates been so low, for so long. Nor has the money supply been manipulated on such a large scale before.

For this reason, I have said that we have reached a 'high' in central banking, just like the Dow Jones can reach a high. From this moment onwards, the credibility of central banks and central banks will be on a downward spiral. If it only were possible to short the ECB…


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