Gary North: Inflation: The Economics of Addiction

I will start my 2014 post with a recommended read from Austrian economist Gary North on the economics of addiction to inflationism.

Inflation: of all the dangers to the free market economy, historically and theoretically, the greatest is this one, yet it is one of those subjects that remain wrapped in mystery for the average citizen. This elusive concept must be understood if we are to return to the free market, for without a thorough comprehension of inflation's mechanism and its dangers, we will continue to enslave ourselves to a principle of theft and destruction.

This essay is an attempt to compare the process of inflation to a more commonly recognized physiological phenomenon, that of drug addiction. The similarities between the two are remarkable, physically and psychologically. Nevertheless, it must be stressed from the outset that any analogy is never a precise scientific explanation. No analogy can claim to be so rigorously exact as to rival the accuracy of the original concept to which it is supposed to be analogous. It is, however, an excellent teaching device, and while it is no substitute for carefully reasoned economic analysis, it is still a surprisingly useful supplement, which can aid an individual in grasping the implications of the economic argument.

Before beginning the comparison, it is mandatory that a definition of inflation be presented, one which can serve as a working basis for the development of the analogy.

One workable definition has been offered by Murray N. Rothbard, who is perhaps the most reliable expert on monetary theory: inflation is "any increase in the economy's supply of money not consisting of an increase in the stock of the money metal." An even better definition might be this one, adopted for the purposes of exposition in this study: "any increase in the economy's supply of money, period." Thus, the level of prices is not the criterion in determining whether or not inflation is present. The only relevant factor is simply whether any new money is being injected into the system, be it gold, silver, credit, or paper.

Unfortunately, many economists and virtually the entire population define inflation as a rise in prices. The more careful person will add that this rise in prices is a rise in the overall price level of most goods in the economy, one which is not due to some national disaster, such as a war, in which the rise can be attributed to an increase in aggregate demand as a result of changed economic expectations. Other economists, even more precise, attempt to define inflation as an increase in the money supply greater than the increase of aggregate goods and services in the economy. Professor Mises himself, in his earliest study on monetary theory, employed a definition involving comparisons between the aggregate supply of money and the aggregate "need for money." But in later years, he abandoned this definition, and for very good reasons, as he has explained:

There is nowadays a very reprehensible, even dangerous, semantic confusion that makes it extremely difficult for the non-expert to grasp the true state of affairs. "Inflation," as this term was always used everywhere and especially also in this country, means increasing the quantity of money and bank notes in circulation and of bank deposits subject to check. But people today call inflation the phenomenon that is the inevitable consequence of inflation, that is, the tendency of all prices and wage rates to rise. The result of this deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages. There is no longer any word available to signify the phenomenon that has been up to now called "inflation." It follows that nobody cares about inflation in the traditional sense of the term. We cannot talk about something that has no name, and we cannot fight it. Those who pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation. Their ventures are doomed to failure because they do not attack the root of the evil. They try to keep prices low while firmly committed to a policy which which must necessarily make them soar. As long as this terminological confusion is not entirely wiped out, there cannot be any question of stopping inflation.

Read the rest here.

I strongly suspect that 2014 will be the year of the Black Swan (low probability, high impact events that have hardly been seen by the mainstream) or what in statistics is known as  the “fat tail distribution”. 

This stage will signify as the traumatic withdrawal syndrome phase for addicts of inflationism.

Mr. North describes this phase:

5. Shaking the Habit

Withdrawal -- the most frightening word in the addict's vocabulary. Depression -- the most horrible economic thought in the minds of today's citizens. Yet both come as the only remedies for the suicidal policies entered into.

To the addict, withdrawal means a return to the normal functioning of the body, a return to reality. The path to normalcy is a decidedly painful avenue. Withdrawal will not restore him to his pre-addiction condition, for too much has already been lost -- socially, physically, financially, spiritually. But he can live, he can survive, and he can make a decent life for himself.

For the inflationist economy, a cancellation, or even a reduction, of the inflation means depression, in one form or another. This is inevitable, and absolutely necessary. Prices must be permitted to seek their level, production must rearrange itself, and this will mean losses to some and gains for others. The inflationary effects of the monetization of debt, the pyramiding of credit, are then reversed. The man who deposited the $100 is pressed for payment by creditors, so he withdraws his money. The banks are faced with either heavy (and unfulfillable) specie demands, or at least with credit and currency withdrawals. The bank calls in its loans, sells its property, and begins to liquidate. The man who bad borrowed the $90 now must pay up, with interest. He goes to his bank, takes out the $90, and his bank has to call in the $81 it had loaned out. The $900 built on the original $100 disappears, again as if by magic. This is the process of demonetization of debt, and it is clear why there would be a drastic decline in prices, and why a lot of banks would be closed, some of them permanently.

The suffering imposed by depression is unfortunate, but it is the price which must be paid for survival. If the consequences of runaway inflation are to be avoided, then this discomfort must be borne. The depression, lest we forget, is not the product of a defunct capitalism, as the critics invariably charge. It is the restoration of capitalism. Free banking, even without the legally enforced one hundred percent reserve requirement, can never develop the rampant inflation described here. The inflation came as a direct result of State-enforced policies, and the State must bear the blame. Sadly, it never does. It accepts responsibility for the politically popular "boom" conditions, but the capitalists cause the "busts."

Such withdrawal phase, or the transitory phase where boom morphs into a bust, will be signaled by a progressive rise in interest rates (expressed via the tanking bond markets) which will greatly impact the incumbent deeply leveraged global financial and economic system.