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There Will Be (Hyper)Inflation

There Will Be (Hyper)Inflation by Thorsten Polleit.

Increasing “Excess Reserves”

The demise of fiat-money regimes around the world has become unmistakable. They can only be kept alive by central banks creating ever-greater amounts of base money and governments underwriting commercial banks’ liabilities.

The US Federal Reserve, for instance, increased the stock of the monetary base – which includes banks’ demand deposits held with the Fed, plus coins and notes in circulation – from $870.9 billion in August 2008 to $1735.3 billion in January 2009.

Banks’ “excess reserves” – banks’ base-money holdings minus required reserves – rose from $1.9 billion to $798.2 billion. These excess reserves allow the banking sector, which operates under fractional reserves, to increase the credit and money supply manifold.

The monetary base expands when the central bank takes over the troubled assets of commercial banks in order to extend new credit to those banks. This process is gaining momentum: on March 18, 2009, the Federal Open Market Committee (FOMC) announced that it will increase base money by purchasing another $1,150 billion of securities. It is also considering increasing base money by extending credit to private households and small businesses.

Causing Inflation

What the Fed does is produce inflation – and this is a truth that stands in sharp contrast to what mainstream economists say, namely that the rise in base money will just increase the liquidity in the interbank market and will not affect the money holdings in the hands of consumers, firms, and the government, which – they admit – could then inflate consumer prices.

In contrast, Austrian economists stress that inflation is a result of a rise in the stock of money. This viewpoint rests on sound economics, firmly rooted in the notion that, first and foremost, value is a subjective concept. Money is a good, like any other, and it is therefore subject to the law of diminishing marginal utility.

A rise in the money stock necessarily reduces the marginal utility of a money unit – and therefore its value – from the viewpoint of the individual; likewise, the marginal utility of a money unit – and therefore its value – would increase if the money stock declines.

Changes in the value individuals assign to a money unit are reflected in prices for vendible items. For instance, if the money stock in the hands of an individual rises, he may wish to increase his holdings of other goods. As he exchanges money against vendible items, the prices of the latter are bid up.

In that sense, the change in the money stock is what must be called inflation, while changes in the prices for goods and services are just symptoms of the underlying cause, which is the change in the stock of money.

What the rise in base money has done so far is prevent prices of banks’ security holdings from declining to free-market levels. In other words, the money injection helps to keep asset prices at artificially elevated levels, thereby preventing prices in financial markets, credit markets in particular, from adjusting.

The Path Toward Ever-Higher Inflation

The government controlled fiat-money regime is highly inflationary, as it allows for an increase in the stock of money mostly through bank credit in excess of real savings (circulation credit). The rising money stock pushes up prices – be it consumer or asset prices (such as stocks, housing, etc.).

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