Inflation Breeds Even More Inflation

I. Warning against Fiduciary Media

Early in the 20th century, Ludwig von Mises warned against the consequences of granting the government control over the money supply. Such a regime inevitably creates money through bank credit that is not backed by real savings—a type of money that Mises termed "fiduciary media."

In 1912, Mises wrote,

It would be a mistake to assume that the modern organization of exchange is bound to continue to exist. It carries within itself the germ of its own destruction; the development of the fiduciary medium must necessarily lead to its breakdown.1

Mises knew that breakdowns of economic activity were the inevitable outcome of government interference in the monetary sphere. However, public opinion has not correctly diagnosed the root cause, regularly blaming instead the free market system—rather than the government—for the malaise. In times of crisis, people call for more government intervention in all sorts of markets, thereby setting into motion a spiral of intervention which, over time, erodes the liberal economic and social order.

It is therefore a rather discomforting truth that today's governments the world over produce fiduciary media, the very kind of money Mises had warned us against.

It is an inflationary regime. The relentless rise in the money stock necessarily reduces the purchasing power of money to below the level that would prevail had the money supply not been increased. Early receivers of the new money benefit at the expense of those receiving it later.

What is more, the creation of fiduciary media artificially suppresses market interest rates and thereby distorts the intertemporal allocation of scarce resources. It leads to malinvestment, which must eventually erupt in collapsing output and employment.

II. The Relentless Increase in Fiduciary Media

The worldwide financial and economic debacle bears testimony to Mises's analysis of the harmful economic and political forces set into motion by a government-sponsored, fiduciary-media regime.

In an effort to fight the correction of the distortions caused by state-sponsored fiduciary media, governments, on the one hand, are running up huge amounts of public debt to finance their outlays—that is, they are engaging in deficit spending

On the other hand, central banks have lowered official interest rates essentially to zero and have expanded the base money supply at unprecedented rates—this is to a large extent a reflection of central banks monetizing the commercial banks' troubled assets. 

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Thorsten Polleit

Dr. Thorsten Polleit is Chief Economist of Degussa and Honorary Professor at the University of Bayreuth. He also acts as ...

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