Governments do a lot of "huffing and puffing" about monetary policy, but the economic fallacies on which the monetary policy edifice is built is never exposed. We are rarely told that monetary policy itself is a fraud.

Changed Meanings

A serious obstacle to understanding inflation is the fact that the meaning of word "inflation" has changed. It is now commonly used as a description of the CPI. Whenever the CPI increases, the news media announce that "inflation" has increased. However, a little thought about the meaning of the word "inflation" gives a hint that something is wrong with this view.The word inflate: means "blow up, dilate, enlarge, swell or expand". The word inflation was originally used in the economic context to describe what was happening to money. The amount of money in circulation was expanding rapidly or being blown up like a balloon. Excessive inflation of the money supply caused a rapid increase in prices, so gradually meaning of the word inflation has changed a rapid increase in the general level of prices.

The meaning of words change all the time, but we need to understand what is going on here. The word inflation was once used to describe the cause of the problem, whereas now it is used to describe the result. People have started to think that the result is the problem and forgotten about its cause. That is nice for those who are the cause of the problem, because they go unnoticed, but it does not help us to resolve the problem.

The verb inflate always has a subject. Someone pumps up the tire. Someone blows up the balloon. It cannot inflate itself. Nor can the money supply increase itself. If the money in circulation has expanded rapidly, someone has inflated it. We must not respond to the change in the meaning of word inflation by drifting into a view that inflation just happens. A rapid increase in the price level is caused by inflation of the currency.

Inflation of the money supply does not just happen, but is caused by someone. The expansion of a balloon cannot be stopped by squeezing it. The person inflating it must stop blowing into it. To get rid of inflation, we must stop those who are doing the inflating.

Governments are the Culprit

A review of the history of money shows that all serious inflations have been caused by governments. Way back in time, currency was issued by banks. Often the notes and coins issued by several different banks would be in circulation together. However, people did not trust the bankers, as they got rich, so gradually governments took over responsibility for issuing notes and coins. Now in most countries, the government has a legal monopoly over the issue of currency.

State control of the currency does not eliminate inflation, but exacerbates the problem. Private banks could inflate the currency they issued, but this was dangerous, because if people caught on, the bank would face a run and be forced out of business. Governments do not face this constraint, because they cannot be forced out of business.

The history of banking is littered with stories of governments that have inflated the currency of their nation. Up till the nineteenth century, they just turned on the printing presses and printed more banknotes. They are now more sophisticated and set up a central bank to manage the process. They inflate the currency by issuing securities and selling them to the central bank.

In the modern world, rampant inflation is always caused by governments inflating their currency. They like inflation, because it allows them to increase their spending without increasing taxation. Big spending politicians are usually to blame.

The worst inflation of during last century was in Germany. During 1922, prices rose by 700 percent. The cause is obvious. 300 paper mills were working top speed and 150 printing companies had 2000 presses going day and night turning out currency order by the government bank. During the following year, prices increased by more than 7000 percent, before the currency collapsed and was replaced.

More recent examples of runaway inflation include Bolivia (1985), Nicaragua (1988), Poland (1989), Brazil (1989 - 90), Peru (1990), Zaire (1990 -94), Russia (1990), Georgia (1992-94) Angola (1994- 97), Argentina (2002), Zimbawe (2006-). In every case, the government was the cause.Only Government

Governments are skilled at finding culprits to blame for their actions. Many of the fallacies about inflation are actually scapegoats that governments blame when they have caused inflation. The following are often blamed, but they are not the cause of inflation.

Only governments have the power to cause inflation. I do not expect governments to discover new and better ways of managing money. They are the cause of the problem, so they will be unlikely to find a solution. They are more like to come with more creative ways of avoiding the blame for the damage that governments do.

A small open economy cannot be insulated from the rest of the world. If the world is awash with money, we cannot avoid getting wet. Gumboots and raincoats make life uncomfortable, but they cannot keep us dry.

A major fallacy is that someone has to control the money supply.

Inflation became a problem when government started printing bank notes to pay for wars and politicians dreams. Therefore the solution to the problem seems be to limiting the printing of banknotes. Governments decided that they would prevent inflation by controlling the amount of cash in circulation. Then someone realized that money on call in a check account at the bank was as easy to spend as a wad of notes, so governments added cash in the bank to their target.

What the politicians did not seem to realise is that the amount of cash in circulation is only indirectly related to the level of economic activity. The amount of cash that I need varies across the month. After I have just been paid, I have a lot of cash on call in my account. Once I have visited the bank, I may have less money in my account, but a stash of notes in my pocket. If can get a better price for something with cash, I may want and even bigger wad of notes. On the day before payday, I may have no cash in my wallet, and all the surplus money in my account may have been put into an investment fund. My cash holdings could be zero.

The need for cash can vary considerably from day to day, but this not something the government should worry about. In theory, everyone could draw all their cash out of the bank on the same day and stock up with groceries. The demand for cash would go up enormously.

On the other hand, it is theoretically possible, though unlikely in practice, that on a particular day, everyone might have spent all their cash and put all their money at the bank onto fixed deposit. Every retail store might have invested their takings, including the cash float. At the end of that day, the level of cash holdings in the economy could be close to zero, but economy would not have ground to a halt. People would go to work the next day and life would carry on as usual.

The demand for notes and coins mostly depends on how quickly people spend their income after earning it. This is not something that governments should be controlling. The volume of cash and notes in circulation is decided by the behaviour of people in the economy and not the government.

The real problem is politicians printing money to pay for their grandiose schemes without increasing taxation. This is what needs to be prevented.

Monetary policy is a fraud. If the government is behaving, controlling the volume of money is not a problem, People can decide how much they want, so monetary policy is not needed. If politicians are misbehaving, then monetary policy will facilitate their misbehaviour. Therefore monetary policy is either not needed, or doing harm. We would all be better off without it.

Interest Rates

Governments used to believe that they could control the supply of money. Now they realise that is impossible and the best that they can do is control interest rates. But even this is too much for them.

The interest rate represents the price that a society puts on the future. It is the price we have to pay to bring purchases from the future into the present. From the other side, it is the price that people get for postponing their spending to the future.

Interest rates should reflect changing attitudes to the future. If people are full of faith and confidence, interest rates should fall. However, if people want to eat drink and be merry, because the future is dark, interest rates will be high. As attitudes to the future change, interest rates should reflect them.

Interest rates affect the level of investment in the economy. If they are low, entrepreneurs will be keen to borrow money and purchase equipment, because they expect a good rate of return. This investment will make the economy more productive. If interest rates are high, many potential projects will be unprofitable. Investment in machine slow and productivity will decline.

The interest rate is a really important price, as it influences many important economic decisions. If it is set at the wrong level, the economy will become distorted and less productive.

In medieval times, the church set the price of bread (the so-called just price). This caused enormous problems, as the price was generally set to low and bread shortages followed. Sometimes, they set the price to high and there was plenty of bread, but people could not afford it. One of the benefits of the Reformation was that the church got out of the price-setting business and let the market set the price of bread.

The communists in the Soviet Union missed the lesson and attempted to control the price of bread for most of the twentieth century. The result was enormous shortages and people queuing for hours to get a loaf of bread.

If bishops and presidents cannot set the price of bread without making mistakes, how can a banker, determine the price of the future. A truly wise man would leave the people of New Zealand to make their own guesses about the future and decide what price they are willing pay to bring things forward.

The Reserve Bank Act allows the governor of the bank to manipulate interests. This is an absurd authority to give to any man, no matter how clever. The chances of a political appointee getting the price of the future right are fairly slim, given that only God knows the future. Alan Bollard does not know the future, so how can he set its price?

Allowing the government to control interest rates is an enormous mistake. They will generally get it wrong.

Cooling the Economy

The current fallacy is that inflation is caused by an economy growing too fast. The governor of the central bank is worried that the New Zealand economy is overheating. He has announced that he may have to increase interest rates to cool the economy, so inflation does not get out of control. This idea that someone has to slow down the economy is absurd. For a start, economic growth does not cause inflation. More importantly, an economy cannot grow too fast.

There are natural limits on how fast an economy can grow. It is constrained by the size of its labour force. The availability of raw materials and capital equipment also act as a constraint on economic growth. If the economy is growing fast, the price of raw materials and capital equipment that are scarce might increase. However, these price increases are good, because they weed out the inefficient producers. The entrepreneur who bids up prices to obtain scarce resources must be able to use them more efficiently than those that miss out. Bidding for productive resources will make the economy stronger; it does not cause inflation.

The wage rates for the skilled employees might also increase, as new businesses vie for the skills they need. Those who are able to attract skilled staff by paying higher wages will need to use their skills more efficiently, so rising wages are also good for the economy. The rising wages also shift some of the benefits of the economic growth to employees and growing incomes provides buyers for the extra goods and services.

An economy cannot grow faster than the engine that propels it. As economic growth comes up against the constraint of scarce skills and resources, less efficient producers will be forced out of business because they cannot compete and the weaker parts of the economy will contract. This process will make the economy stronger as inefficient producers are replaced by those that are more efficient. Once all resources are in the hands of the most efficient producers, a new business will have to extremely efficient just to get started, so the rate of growth will slow to match the growth in productive resources.

The economy can look after itself. It does not need a government appointed monetary policy expert to slow it down.

Central Banker Frailty

Central bankers who think they need to manage the speed of the economy face two major problems. The first is that the economy does not have a speedometer. The best statistical measures of economic activity arrive too late and are not sufficiently precise to accurately measure the speed of the economy. So most of the time, the central bankers do not know whether the economy is growing too fast or too slow. They will often take the wrong action.

The other problem is that controlling the interest rate is a very blunt instrument. When using interest rates to slow the economy, central bankers hurt all businesses, not just those which are least efficient. Higher interest rates prevent efficient businesses from expanding and may cause some to shift overseas. Exporters are often hurt by the consequential rise in the currency.

On the other hand, reducing interest rates to speed up the economy encourages all businesses to expand, when it would be better if only the more efficient ones grew. Worse still, the low interest rates can cause distortions in the economy, by encouraging speculation in fashionable assets.

Distorted Growth

An economy cannot grow too fast, but monetary policy can distort growth by causing parts of the economy to grow too fast. The current housing boom is a good example of economic distortion fostered by monetary policy. Without loose monetary policy, the speculation in housing would have died quickly as supply and demand responded to prices.

The housing sector has grown too fast, but this distortion only occurred because central bankers put their foot on the accelerator at the wrong time. Now they want to take their foot of the accelerator, but disrupting the entire economy does not make sense.

Monetary policy does distort the economy. Worse still, monetary policy cannot eliminate the distortions it creates. The best that central bankers can ever do is to create a different distortion, so allowing them to "correct" an economy that has been distorted by their mistakes is totally foolish. Punishing exporters to control a housing boom is unwise.Economic growth does not cause inflation. Inflation of the currency causes economic distortions that disrupt the economy.

Housing and Inflation

Modern people live with an assumption that house prices will always rise. This is a false view. The intrinsic value of a house declines over time as it deteriorates and become old fashioned. What actually happens is the money loses its value over time, as central banks and governments manipulate their country's currency. People confuse a decline in the value of money with an increase in the value of their houses. That latter is an illusion

Warning

Most of the time, central bankers are taking actions to fix up problems caused by their own mistakes. Allowing them to slow the entire the economy to eliminate a problem they have caused is like giving the key of your house to the pickpocket who stole your watch.Houses and Inflation

Leverage and Inflation

The credit crunch left banks, hedge funds, private equity firms and other businesses throughout the world with balance sheet problems. The market value of the financial instruments on the asset side of their balance sheets has plummeted. In many cases, their value cannot be determined, because there is no longer any market for them. The purchase of these assets was leveraged by borrowing some of the credit that used to be so readily available.

The problem is that the value of the debt on the liabilities side of the balance sheet does not decline in value. The debt still has to be repaid in full when it fall due. This means that the decline in value on the assets side is a hit on the owners equity. In many cases the value of debt is greater than the value of the assets, so the owners equity has gone negative and the business is inherently worthless.

The solution to this fiasco that is preferred by the clever people is two or three years of inflation at a rate of 20% to 30%. During inflation, the market value of the assets on the assets side of the balance sheet increases, while the nominal value of the debt on the liabilities side remains fixed. This increases the owner's equity and restores the viability of the business.This inflation should be opposed. Inflation wipes out the value of the savings of the people who have been responsible and rewards those who have used debt and leverage to speculate on property and other financial assets. A better solution would let those who have used debt and leverage reap what they have sown, and protect those who have been prudent.