Ergo inflation

I was still wondering how these mind-boggling bailouts will affect the value of money. So to find out more, I picked up a 10-year-old book called Paper Boom, a critique of the Canadian financial system. The author makes some interesting points*, but there is something he mentions in passing that really caught my eye.

When talking about the value of money, we're really talking about inflation. In theory, inflation occurs when the money supply expands faster than the amount of real goods and services (or shrinks more slowly). With more dollars in circulation for the same number of goods, the price per good goes up. Nobody wants that** because it means the purchasing power of our salaries and savings shrinks every year. We can't just keep the money supply artificially low because then there is a shortage of currency, which leads to an inefficient barter economy. Since we can't easily control the total amount of goods and services, we control the money supply to avoid inflation.

I thought that the government controlled the money supply by minting, physically or electronically, any money used in commercial transactions. Loans or bonds wouldn't change the total money supply since they are simply a transfer from one person to another. In fact, that's quite false. Only about 5% of wealth created is issued by the government. The rest comes from a special power that banks have called "creation of credit". By law, banks can lend more money than they actually have. So if they have $1 million in liquid assets, they can lend $10 million and thereby increase the total money supply. That sounds like a bad thing--I have visions of 1929 bank runs--but as I explained above, the money supply does need to expand*** in order to keep up with the increase in goods and services, and bank loans are an efficient way of doing that. It would be difficult for a central planner to accurately match monetary and economic expansion, but since banks lend (newly created) money to purchase newly created goods, there is a close match. That being said, there is a logical consequence: the interest charged on this created credit leads inevitably to inflation. I'll illustrate what I mean below.

Suppose a community produces 100 units per year of real goods and services at $1 apiece, say food and music, and that increases by 5 units per year. That's the real economy. We'll neglect government wealth creation by assuming old currency wears out as quickly as new coins are minted. Each year, citizens take out loans (since the money doesn't exist yet) to buy the additional goods. The economy expands by 5 units/year and the money supply expands by $5/year; therefore the goods will still cost 1 $/unit the next year and there is zero inflation. However, banks don't lend for free: they will charge interest on the $5 loan. This extra dollar or partial dollar means that the money supply is now larger than the real economy, so there must be inflation to compensate. Ergo, any interest charged on bank loans causes inflation.

The next question is, how much does this contribute to real-world inflation? Canada's real economy was valued at $1150 billion in 2007 with yearly economic growth of about 1.5% and 2.5% inflation. Interest on bank loans was about 5%. So inflation from bank lending is

(economic growth)x(loan interest rate)/(size of economy)=(1.5%x$1150 billion)x(5%)/($1150 billion)=0.075%

Which is only a tiny fraction of the actual inflation. So I guess it isn't a major factor.


I realize that there are several important factors I've neglected in this analysis--I was just so astonished that banks create wealth that I had to write this down. For the sake of brevity, I'll just mention one of them. We know that human industry and commerce are damaging our planet's life support system and depleting natural resources. Expansion of goods and services, which mainstream economists take as their goal, is a central cause of this degradation. Therefore it would be preferable to halt inflation by freezing economic growth and minting a constant amount of currency. That is, to invest in reduced waste rather than growth for its own sake. I don't know the best way to achieve that, but there will need to be public analysis and control of resource exploitation and pollution rates to safeguard our environment's life-support capabilities and allow continued prosperity.


*Author Jim Stanford mostly tells us what we already know--our financial system is hyperactive, mostly pointless, heavily subsidized, unfair, detached from reality, and prone to catastrophic crashes--but he goes into depth and lucidly explains how and why this is so. A few things he said were surprising:
First, although theoretically its whole purpose is to channel savings into productive investments, the financial sector only handles about 3% of real investment. The rest is performed via retained earnings by companies, individuals, or governments. That productive investment accounts for about 5% of financial activity, and the rest is entirely casino capitalism.
Second, most successful companies in Canada are insulated from the destructiveness of the stock market through majority ownership by a family or individual.
Third, mutual funds are for suckers: they nearly always underperform the stock market as a whole. Mutual fund brokers do so well because they spend hundreds of millions of dollars on advertising and because they get large subsidies through the RRSP system.

**Some argue that inflation is really only a problem for those who are already wealthy. In Canada, the poorest 30% (family income < $30 000) have such a low income that they never accumulate any savings. The middle 60% ($30 000-$250 000) usually invest any surplus income in paying off their mortgage, so as long as their wage keeps pace, they actually benefit from inflation. The richest 10% (family income > $250 000), whose assets and real estate are paid-for, invest their surplus income in the financial system, and that is where inflation is a big problem. So for 90% of Canadians, high employment and wages is much more important for their financial well-being than low inflation. I agree with that under normal conditions, but what I'm worried about is hyperinflation, which is very harmful to the poorest 90%.

***For commerce to function, the money supply needs to keep pace with the expansion of the real economy. However, banks are given the power to create wealth but not a mandate to do so. This can lead to serious problems when, for one reason or another, banks refuse to create wealth (ie lend money). That's exactly what happened last fall; bankers panicked over the collapse of the stock market and caused a paralyzing "credit crunch" until they were bribed to lend money again.