April Freeman Banner 2014


Built-In Pressures to Inflation


All the obligations of the United States government, both actual and potential, stand today as pressures toward inflation. They are like a vast sea lapping at, thrusting against, and threatening to crash through the defenses built against it by a succession of casually thrown up dikes. Indeed, the momentum lies with inflation, and the pressures mount with each new obligation undertaken and every old obligation that comes to maturity.

Inflation is used in two somewhat distinct ways today. It is used by some economic thinkers to refer to the increase of the money supply.

Popularly, it is used to refer to general rises in prices. If it be understood that the increase of the money supply is the cause of the general price rise, much of the objection to the second usage is removed. Not all of it, however. There would still be an unmeasurable phenomenon with no name and no way to identify it if inflation could apply only to general rises in prices. The reason is this: It is possible to have increases in the money supply accompanied by no general price increases. Indeed, it is conceivable that over some period of time increases in the money supply might be accompanied by a slight decline in prices. There may be a variety of reasons for such effects. The additional money might have gone into savings. There may have been productivity increases which offset the increases in the money supply. (In which case, prices would have fallen, or fallen more than they did, had the money supply not been increased.) In any case, if inflation refers only to increases in prices, it will only be noted when prices actually increase. More importantly, if inflation refers only to price increases, it may be, and frequently is, separated from its basic cause—increases of the money supply by government. For these reasons, inflation is used here to refer to increases in the money supply.

A Form of Taxation

The effect of inflation, whether it results in a measurable increase in prices or not, is that it levies a tax on all who have money or have it owed to them. It reduces the value of the currency, and the amount of that reduction is used by government to pay its bills. In the United States today, the government inflates by monetizing debt, its own debt directly and other debt more indirectly. The only limits to the money supply are arbitrary reserve requirements on banks and changing debt limits set by Congress. These are the thin and flexible dikes holding back the onrushing sea of inflation.

What are these pressures to inflation? The most obvious one, of course, is the national debt. It has now reached or passed $600 billion.

The debt presses us toward inflation in two ways. One is by way of paying the interest on it. The annual interest on the debt is now in the $30-40 billion rate, and has lately been rising more rapidly in proportion than the national debt. The interest must be paid from taxes or by inflation. An even stronger pressure to inflation is the continual refinancing of portions of the debt. The debt is not being retired but it is being continually paid off and renewed as bonds and other securities mature or are cashed by their holders. This is inflationary to the extent that the refinancing is by way of monetizing the debt. In a similar fashion, any growth in the debt is likely to be inflationary.

But the national debt is only the best known and most obvious obligation of the United States government. It is actually only the exposed tip of the iceberg of obligations. Among these, the obligations under Social Security may be the next best well known. From time to time, calculations are made as to the extent of Social Security obligations. None of these need detain us, however, for they are only projections based on current payments, commitments, and longevity expectations. Since cost-of-living adjustments are now made regularly, Congress periodically adds new benefits, and the number covered is expanded, there is no way to calculate the amount of the obligation. Suffice it to say, the obligation is immense and the amount of it rapidly rising.

Social Security Deficits

Social Security is already beginning to exercise inflationary pressure. For most of its history it did not do so. Income into the program exceeded the payments out of it. A “fund” was being built up. More specifically, Social Security payments were helping to finance the national debt. Now, however, that has changed. Social Security is paying out more than it is taking in. The difference is being made up by the sale of government securities. For the time being, the result will not necessarily be any net increase in the debt, but it will bring on inflation to the extent that the debt is refinanced by monetizing it. This inflationary pressure will mount to the extent that the gap between intake and outgo widens. When and if the “fund” is exhausted, the pressure may be expected to be revealed, at least in part, in increases in the national debt.

One of the most direct, though least known, pressures to inflation is government obligations contracted by serving as guarantor of mortgages. The best known of these guarantees are the VA and FHA guarantees. The United States government guarantees up to 20 percent of VA loans, a guarantee which enables veterans to buy houses with no down payment, if they can otherwise meet the requirements of a lender. The FHA insures loans on which the house buyer may make as little as a 5 per cent down payment. There are a considerable variety of other government guarantee .programs in real estate, but enough has been told to show the principle of guarantee underlying and making the government obligations.

Such guarantees as these tilt government toward inflationary policies. It is generally claimed that VA and FHA loans have been successful in that losses have been small. There is not much mystery as to why this should have been so. Impractical programs have been saved from their predictable consequences by long-term inflation. It has worked in two ways to do this. One is that wages have generally risen over the years, making it easier for the mortgagor to make his payments. The other is that any house tolerably well taken care of over the last twenty or thirty years has appreciated in dollar value, other things being equal. This has meant that the owner could usually sell it for more than was owed on it, however much that might be, or, if foreclosure did take place, the amount of the mortgaged indebtedness would probably be recovered. The real guarantor of the mortgages, then, has usually been inflation.

It might be supposed that the government obligations on mortgages are limited to the extent of the guarantees. This is only superficially the case, however. Government obligations extend to cover a large portion of the mortgaged indebtedness in the United States. They do so because the Federal government guarantees most of the deposits in banks and savings institutions by the Federal Deposit Insurance Corporation and the Federal Savings and Loan Insurance Corporation. In turn, mortgages constitute a large portion of the assets of banks and savings institutions. It is reasonable to suppose, then, that if governments had to pay off depositors and savers they would, in effect, be making good on these loans. Continuing inflation enables banks to operate with relatively small reserves, particularly when the very mode of inflation is the monetizing of debt.

Government Guarantees

The total obligations of the United States government include both formal and tacit or informal obligations. The government underwrites more kinds of undertakings than the present writer knows or could describe if he did. A vast assortment of projects proceed on the basis of such underwritten guarantees. Beyond these, the government has thus far shown a willingness to shore up any failing business, city, or government. The loans to Lockheed, the aid to eastern railroads, the subsidizing of AMTRAK, illustrate the government’s role in business. The recent bailing out of New York City shows the possibilities of government action in the area of local government.

How can the federal government act as guarantor for and come to the rescue of all these people and institutions? Is it because the federal government is so well managed and has so many resources upon which to call? Not basically. The federal government’s finances have been no better managed, if anything they have been worse managed, than Lockheed or Penn Central or New York City. It is sometimes alleged that the federal government is an efficient taxer and has a much better base for taxes than state or local governments. This may or may not be true, in theory, but in fact for many years running now it has spent more than it has taken in by way of taxes. In short, the claim if correct is nonetheless irrelevant. The difference between the federal government and these private businesses and other governments lies in the power to inflate, the power to increase the money supply by monetizing its debt. The vast obligations of the federal government are “secured” by the debt itself. These obligations are the potential of mounting waves which could destroy our money supply even as they wiped out the indebtedness.

Political Pressures

There are other pressures to inflation than those that arise directly from obligations of the government. They are what may be called political pressures. Some of these pressures evince themselves in the desire of politicians to spend while avoiding the onus of taxing to get the money, or all of it. There is a multiplier effect to this kind of government spending, though not in the sense in which some economists use the word. By raising less by taxes than is spent, by making up the difference with fiat, i.e., printing press, money, the government puts more into circulation than it takes out. The initial impact of this additional money, if it is not entirely discounted, is to spur investment and all sorts of risk taking. An aura of prosperity quite often accompanies the spurts of new money. In the long run, whatever time it takes for the untoward effects of inflation to take place, the aura of prosperity dissipates as prices rise, wages lag, and malinvestments induced by false signal assent into the market produce their inevitable crop of failures. The long runs grow shorter and shorter, too, with successive spurts of inflation, for people come more and more to expect that the aura of prosperity is only an aura. The stock market, for example, can remain bearish through a whole series of spurts of inflation.

There are, then, two rather direct political pressures to inflation. One is for politicians to be able to spend and avoid the responsibility for new taxes. The other is to create the aura of prosperity at crucial times. Presidents have come to depend on this inflation-induced aura of prosperity in the months just before a presidential election. If the President is a candidate himself, he will press to do it in his own behalf. If not, he may be expected to try to do it on behalf of his party. It might be supposed that the members of Congress of the party out of power would want to thwart this effort, but it does not follow. Their reelection may be dependent also upon the appearance of prosperity. It may well be that the greatest danger of a runaway inflation arises from the political necessity for prosperity in an election year when it is coupled with mounting popular resistance to accept the false signals sent into the market by inflation. The pressure is there to pour more and more money into circulation to achieve the desired result. This tide of inflation could knock sufficient holes in the dikes to allow the whole sea of claims on government to sweep through and destroy the money.

Hikes in Minimum Wage

Congress and the President reap political gains in yet another way that depends on inflation. They periodically raise the minimum wage, increase the pay of government employees, give raises to those on pensions, such as retired military personnel, and so forth. Not only is inflation sometimes named as the reason for these increases but it also makes them possible. Without the inflation, there would not be these rounds of increases which members of Congress particularly call attention to in order to claim credit from some of their constituents.

Labor unions contribute considerably to the pressure for inflation. To keep its following, the union finds it expedient to demand and get higher wages in each successive contract. Union officers seek also to maintain and even increase union membership because their salaries depend upon the number paying and amount of the dues and the effectiveness of the union is tied to its financial resources in a variety of ways.

These two goals—perennial money wage increases and stable or increasing union membership—are incompatible in the short run and impossible in the long run, except under one condition, a regular and continuing expansion of the money supply. All other means of accomplishing this are strictly limited in their application, and self-defeating when employed over an extended period of time. (Indeed, inflation is self-defeating also, but not so obviously or directly.) For example, it is often alleged that wages could be increased by giving workers a larger proportion of the gross income of a company. But this could not continue year after year indefinitely, for there is only 100 per cent, and eventually wages would take all the income. Long before that occurred, however, the company would have been driven out of business, and union membership reduced by the number disemployed. For an industry as a whole, the process would be less dramatic. The price of the product or service would be increased to cover the higher wage costs or machines would replace workers. In any case, the number of workers, i.e., union members, would decline. Another device that allegedly could result in money wage increases would be increased productivity. But overall increases in productivity will not result in money wage increases, in the absence of an increase in the money supply; the result, given competition, will be a reduction in prices of product or service. Lower prices would increase the real wages of workmen, but unions could hardly claim credit for the increase, since money wages would remain the same, or might even decline.

In sum, unions depend on inflation for their growth, and, with some few possible exceptions, even their survival. The periods of dramatic union growth—World War I, the 1930′s, World War II and after—have been periods of inflation. The only extended period of continued large scale union membership in our history has been one of a continued and long-term increase of the money supply, namely from the 1930′s to the present.

A Fearsome Burden of Debt

There are, then, a host of pressures toward continued and mounting inflation. Some estimate that the total obligations of the government now amount to something like $5 trillion. If that figure was correct yesterday, it has probably already been surpassed now, and will continue to grow larger if the government persists in contracting more and more obligations. The obligations of the government are such that if all of them had to be met that could only be done by such a massive inflation that the value of our money would be destroyed. Not only that, but if the government had to pay off on all that it has underwritten, it would surely become receiver for the banks, savings and loan associations, many industries, and a considerable portion of the homes and landed estates in the country. These “guarantees” are backed by debt; they are potential massive pressures to inflation, and the present means for meeting the obligations is the monetizing of debt.

There should be no doubt, then, that the government is on a course that if followed will destroy the money, may result in government’s becoming receiver for increasingly large amounts of property, and will almost inevitably lead to loss of faith in the government. Someone looking at this from another planet or an enemy country might view all this with equanimity, or even with glee. After all, they might say, the government has made its bed, let it lie in it. Those of us who live in the country, who would not know where to go to find better circumstance if we would, must perforce view the matter differently. The government may have made the bed, but all of us are going to lie in it. If there is some way to avert the collision between money supply and obligations, some way to reverse our course without, say, ruinous deflation, we would wish to find it.

There are some things that should be done. They should be done because they are in the right direction and because they offer some prospect of working. It needs to be clear, however, that in offering them the present writer is steering as clear of detailed monetary theory as he can. He is not going to say what should back our money, how much reserves banks should have against deposits, who should issue the currency, or any other of hundreds of questions that could be raised. His predilection is to have as many of these questions answered in the market as possible, but even that is put aside somewhat here in order to stick as close as possible to some general principle. The reasons for these limitations should become apparent in what follows.

No Drastic Changes

Whatever the remedy for the situation there may be, there is one thing it should not be. It should not be drastic. Whatever is done will affect established institutions, contracts, wages, prices, and a whole complex of delicate relationships. The least direct and immediate effect there is on any of these the better. Nor should the action taken excite unnecessary fears about the possible consequences. For these reasons, only so much should be done as produces the desired change of direction.

Two things only need to be done. They are interrelated in that the first will almost certainly lead to the second. The first is to stabilize the money supply. A stable money supply need not be and probably could not be a static money supply. It only means that the pressures to the increase of it be counterbalanced by pressures to decrease it. This is what is meant by or produces stability in any thing. The second is to build in pressures toward fiscal responsibility by the government (and individuals, and companies, and banks, too), toward the reduction of debt, toward balanced budgets, toward .reduction of government obligations, and toward the disentanglement of government from the economy.

Some have apparently hoped that political pressures could be built up to counterbalance the thrusts to inflation. This hope probably underlies at least some of the effort to inform the public that government’s increasing of the money supply is at the root of inflation or what is causing it. It is a forlorn hope. If everyone in the country, including small children, knew that inflation is the increase of the money supply and that government is the villain of the piece, my guess is that the political pressures would not be significantly altered. The reason is not far to seek. The only ones hurt by inflation are all of us, though admittedly some are hurt worse than others, at least in the intermediate stages of it. Hence, the resistance to inflation is vague, general and diffuse, apt to be relegated to the realm of hankerings for a good five-cent cigar. By contrast, the benefits of inflation are particular, immediate, and accrue to those in the seats of power, i.e., politicians. All of us wish that the prices others charge would be stable or even decline, but each of us wants even more to get more for what we sell. Inflation feeds on the lure that we can do this, though it is almost entirely an illusion.

Remove Monetary Powers

There is little likelihood, then, that political pressures can ever be built up that will counter the built-in tilt toward inflation. This is just another way of saying that government cannot be trusted with the power to manage the money supply. That is not surprising, after all. No one of us could be trusted with such power. If one of us is multiplied by 500, or 5,000, he does not thereby become more trustworthy, though he may well become more devious. Give any man, or group of men, control of the money supply, couple it with the possibility that he can benefit by increasing it, and the question becomes not whether he will do it but when. Each of us has enough “Après moi, le deluge” not to be deterred from acts simply because they will have some dire consequence in the uncertain future.

What needs to be done, then, is to divest the federal government of its power to increase or decrease the money supply. The expansible and contractible portion of the money supply today consists of the outstanding currency plus demand deposits in banks less the reserves held against the deposits. The money supply can be increased by increasing debts, both those of the federal government and private debts. The government manipulates this or controls it by setting reserve requirements for banks and by the sale or buying of securities by the Federal Reserve banks. Since there is no real limit to indebtedness, the only limit to the money supply is the reserve requirement, but it can be lowered virtually at will. Our money is money by the decree of the government—fiat money—, separated from this only by the backing it receives from the debt.

Two changes in the system would set up major and probably sufficient counter pressures to inflation. They are changes of a character that most people would hardly notice. One would be to prohibit the monetizing of debt, both public and private. It should never have been permitted in the first place. Debt is no security for anything, least of all money. It is fraudulent to pass off as money what is secured only by debt. The most effective way to accomplish this prohibition would be by constitutional amendment.

Reserve Requirements

The second change would be in the reserve requirements. There are, it has been noted, two ways that money is created: by printing currency and by creating demand deposits in banks. If debt could not be monetized, there might still be a way for government to manipulate the money by altering reserve requirements. The device involved is called fractional reserve banking. Two varieties of fractional reserve have been practiced historically. One is the reserve against the currency. When currency was backed by and convertible into gold, banks of issue usually had a reserve in gold against their outstanding currency, a reserve which was only some portion of the total—a “fraction” of it. This practice of having fractional reserves against the currency has been continued, though today it means little by way of restraint. The other kind of fractional reserve is the reserves in cash which a commercial bank holds against deposits. Both varieties of fractional reserve can be and are used to increase the money supply.

There is nothing wrong, per se, with operating on fractional reserve. It is an old and reasonably honorable practice. Banks are not the only institutions which keep on hand only a fraction of the amount needed to pay off all their obligations, if they should have to do so all at once. So do savings institutions, insurance companies, furniture stores, appliance dealers, and companies of every sort and description. Hardly an individual could be found who has the cash on hand to meet his forthcoming obligations. He expects to pay them out of income as they come due, keeping on hand only sufficient cash for emergencies, if he is prudent. Banks do likewise, though admittedly much of their “income” consists of deposits by their customers.

At any rate, fractional reserve in general is not at issue here. What is properly at issue is any fractional reserve held against the money supply. There is no excuse for a fractional reserve against the money supply. Money should be backed by a 100 per cent reserve of what is used to back it. Anything less is fraudulent and should be punished the same as any other fraud. Any reserve of less than 100 per cent amounts to a false claim as to the character of the money issued. Currency, then, should be backed by 100 per cent reserves against it. If those reserves cannot be debt, they must consist of some sort of assets, assets whose value could be determined in the market place and which, if they had to be produced, would equal in value the currency issued against them.

Bank deposits can be held in check and limited by requiring that there be in reserve against them either cash or collateral in the amount of 100 per cent or better. The effect of this should be that banks could only create a deposit on an unsecured loan—debt—by increasing their cash reserves in an amount equal to it. This would not prevent some fluctuation in the money supply, but it would create pressures to hold the supply in check.

How would government service its debt if it could not do so by monetizing it? It could do so in the same way other organizations and individuals service theirs, namely, by borrowing from willing lenders who will lend on unsecured notes or by putting up sufficient collateral to secure the loans. Since banks would have little inducement to grant unsecured loans, such loans as government could obtain without security would be uninflationary. If government put up collateral, such as national forests, this could result in some increase of the money supply, but there would be inherent limits to and checks upon it.

In short, if government could not monetize the debt or manipulate the reserve requirements, the counter pressures to inflation would be developed. Government would either have to raise the moneys it spent by taxes or by divesting itself of its assets. The pressure would be on to reduce the debt. The pressure would be on to reduce obligations. Government would have very little incentive to increase its obligations and strong motives to reduce them. Every pressure to inflation, both public and private, would be matched or counterbalanced by pressures to reduce and pay off debts. There is no reason why these two changes should be strongly inflationary or deflationary. All the money in circulation could remain there, provided only that backing were found for it. All debts and obligations would stand as they had been, counterbalanced only by a pressure to reduce and pay them off. Government would no longer control the money supply; it would, instead, be held in check by it.


September 1976

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