On Nov. 20 of last year this column stated, "The solution for inflation is well known, but the cure could be worse than the disease." Since then, a number of readers have asked about this "cure."
High labor costs, big government, oil price increases, and other factors may be blamed for causing inflation. But these are symptoms, not causes.
Inflation results from too many dollars. Rather than an increase in prices, inflation is the decreasing value of our money. One is the mirror image of the other. To understand the basics of inflation, one must not be distracted by the money illusion that the dollar (or any other currency unit) remains stable.
Here is a simple example to clarify the concept: If $100,000 exists in a mini-economy and 100,000 units of merchandise of average value are available for purchase, the average price for each unit would be $1. But, if the supply of money is increased to $200,000 by issuing an additional 100,000 dollar bills while the same number of products remain available, the average price of each unit increases to $2.
Does the price inflate to $2 for each unit? Or, is the purchasing power of each dollar cut in half and, thus, require two dollars to purchase what one dollar has purchased before?
Since 1939 the money supply in the United States has grown from $34 billion to $380 billion, an increase of roughly 1,118 percent. Prices have risen at a lesser pace with the purchasing power of a dollar roughly 20 percent of its comparable purchasing power in 1939. The nation's population and output have increased dramatically in the same years.
So much for the cause of inflation. Inflating the money supply provides a number of temporary benefits -- more demand for goods that, in turn, generate more jobs to produce those goods and more perceived purchasing power from a greater flow of dollars.
During the initial phases of inflation, a feeling of euphoria develops. When inflation appears to get out of hand, increases in the money supply are cut back. The economy slips into a recession, and unemployment increases. Then economic policy is once more reversed: More money is created to stimulate demand , which causes more inflation, and eventually tight money again and increased employment. The trend through numerous cyclic ups and downs has been toward more money and ever higher prices.
Curing inflation by decreasing the money supply isn't satisfactory either. This is the cure that would likely be worse than the disease, as jobs and money would be severely limited. But, continuing to increase the money supply will lead eventually to a repudiation of paper currency. This has happened in every country in history where the monetary system was based on paper alone. Only since Aug. 15, 1971, has the dollar not been convertible into gold.
Deficit spending often results in an expansion of the money supply, so it can be borrowed without running up interest rates. A portion of the debt is monetized; that is, more money is created to balance spending. A more efficient government could provide the services supposedly needed without increasing the number of dollars. A drive to improve supply and productivity could decrease the relative price of goods and thus, continue increasing our standard of living. Neither of these long-term solutions is likely until politicians and voters understand the "money illusion."