The Emperor’s New Clothes: Inflation and the Psychology of Money – Part Two
The first part looked at three possible paths to higher inflation: cost-push when the price of an important input increases, resulting in higher prices for a multitude of goods and services; salary-price when an expectation of rising prices leads to a demand for higher wages, leading to higher prices and an inflationary spiral; and finally, a monetary crisis where a loss of confidence in the value of money leads to higher prices and, in some historical cases, hyper-inflation. Part 1 ended with the question: what, in the current environment, could cause a loss of confidence in the value of money. The second part tries some answers.
As noted at the outset, recent increases in government spending and central bank money supply have raised questions as to whether these are harbingers of higher inflation. Because common sense dictates that an increase in the supply of something devalues it, this is not an unreasonable concern.
The money supply can grow in two obvious ways: informally through forgery and officially through politics.
Counterfeiting has a long and, dare I say it, a rich history. Counterfeiting, which has been dubbed the second oldest profession in the world, has probably existed since the money itself. Before paper money, coins were cut around their circumference with the shavings used to make new coins. For this reason, milling has been introduced on the edges to prevent the parts from being tampered with. Another approach was to replace the middle of the precious coins with lower metals, as happened with the silver denarius in Rome and the drachma in ancient Greece. The advent of paper money widened the possibilities of counterfeiting, including as a weapon of war.
Lenin allegedly claimed that the best way to destroy the capitalist system was to debauch money. He was reportedly “obsessed with a plan to wipe out the power of money in the world,” and said: “Men will stop coveting and accumulating it as soon as they find out that it won’t buy anything. . , and the great illusion of the value and power of money, on which the capitalist state is based, will have been definitively destroyed.
During World War II, the Nazis used Jewish prisoners to counterfeit pounds sterling with the aim of knocking them down from the sky to undermine the true value of British currency and crater the economy. In the event that the Nazis were unable to perform their fake sterling airdrop, the intention was clear: to use counterfeit money to undermine confidence in all money. To this extent, it was an application of Gresham‘law, which is named after a financial adviser to Queen Elizabeth I and simply declares that “bad money drives out good”.
In Gresham’s day, bad money was a debased coin, which risked putting good money out of circulation as everyone accumulated non-counterfeit coins. Queen Elizabeth has clearly listened to her advisor, making currency reform one of her government’s priorities. If caught, counterfeiters were systematically hanged. In 1741, an Act of Parliament characterized the counterfeiting of coins as high treason, implying that such counterfeiting was a criminal act directed against the head of state. Between 1805 and 1818, convicted forgers or forgers accounted for nearly one in three people executed in London and Middlesex, and one in five in England and Wales. These penalties were severe, but the consequences of counterfeit money are real and include financial losses, as payments made with counterfeits are not refunded; a loss of confidence in the value of money caused both by an increase in supply and by uncertainty around what is official and what is not; and a general increase in prices due to this loss in the perceived value of money. This begs the question: what is the likelihood that an unofficial “airdrop” of counterfeit books is today? While the move to a fully digital currency may require reassessment, modern methods of creating banknotes currently coupled with advances in technology to detect counterfeits mean that successful large-scale counterfeiting is unlikely.
While an unofficial increase in the money supply may be ruled out, what cannot be ruled out (not least because it is already happening) is an official increase. Depending on the measure of currency used, the money supply in the UK has grown by 20 to 30 percent over the past two years. At the same time, public debt as a percentage of GDP increased from 85% to 105%. Official money and public spending have increased markedly. Inflation has also increased – it has almost doubled in the past two years.
Whether higher official largesse will lead to ever higher inflation divides opinion, but any reasonable account must explain what has happened in Japan over the past three decades. For many years, the Japanese economy has been described as “a bug in search of a windshield”. Yet since the bursting of their real estate bubble thirty years ago, the Japanese have experienced sharp increases in both public debt and money supply without much inflation. During this period, the public debt as a percentage of GDP almost tripled, and the money supply as a percentage of GDP increased sevenfold. At the same time, the value of 100 fell to 88, while unemployment did not. averaged just 3.7 percent. By comparison, the same figures for the UK are doubled, quadruple, at £ 48 and 6.5 percent. So it seems that while an official currency increase is a necessary precursor to higher inflation, it is in itself insufficient. Another way of saying this is that even if more money creates kindling, it still takes a spark to start an inflationary bonfire.
In The emperor‘New clothes, the Damascene moment comes because of a child crying out the obvious with his own eyes. It remains to be seen what causes a similar moment of falling scales when it comes to the purchase value of silver. It will not be because the government “lacks money”. Countries like the UK and Japan that have their own non-convertible (i.e. fiat) currencies cannot, by definition, run out. But at some point, if the balance between the supply of money and the supply of goods and services in the real economy tips too far, inflation will ensue. If left unchecked, inflation will create a crisis of confidence in our money: “The Emperor wears nothing at all!
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