Ben's Talk3G Blog

Ever wondered why economists and the media are so obsessed with inflation? It's a helluva lot more complicated than you might think.

Our monetary system actually requires a stable level of inflation to function, a number that our government puts at around 2%. What that means is that the amount of money in circulation is growing faster than the value of 'real things', be it food or houses, that actually exist. As a result, you need more money to equal the perceived value of a given 'real thing' - money itself, remember, has no value whatsoever.

So why can't we target a 0% rate of inflation, so the value of 'real things' only changes depending upon things like supply and demand rather than the money supply?

Quite simply, before long there would be no money left.

Banks make loans. They don't give away money they have in a safe somewhere, they actually 'make' the loan - it's brand new money, usually created against the value of something, like your house.

You then pay that loan back to the bank, using money from the money supply - i.e. earned via your job. But that's OK, you boosted the money supply by the same amount when you took out the loan and paid the seller of the asset.

Wrong. Why? The bank adds interest to your loan. So you don't just repay the 'new' money, you have to repay the interest, too, the bank's profit. Where does the interest come from? Well, that also comes from the money supply... but if all money is created as loans, as debt, then surely by now you can see the problem - there will never be enough money to repay all the loans plus all the interest from a money pool that only consists of all the loans.

Loans (money in circulation)
As a result, some people will not be able to repay their loans. Usually that's not a problem for the bank, because they get to seize the asset, i.e. the real value. But the recipient of the loan is, well, screwed.

But the system would still break completely unless there was a mechanism for keeping the money supply growing. That mechanism is inflation.

Our monetary system requires that we keep borrowing more and more money, injecting it into the money supply, so that the majority of existing loan holders can suck that money, plus interest, out of the system to pay the banks. This ever-increasing amount of money required in circulation means that asset prices can also keep increasing, meaning each new loan can be for a larger and larger amount. The inflation also devalues the loan itself - in a perfect 'debt money' world, our house value increases during the life of our mortgage, so the debt effectively shrinks.

Unfortunately inflation means that if you hold cash then you need a very good rate of interest to be paid on it, at least equal to the rate of inflation in the money supply, or the value of that cash will actually be shrinking!

Deflation, then, isn't scary because people will hold off buying things until they get cheaper. No, BBC News, that's really not it. It's scary because if the value of 'real things' is going down, then the value of new loans will probably also go down, and that means less money being injected into the money supply, less money to go around, and more people defaulting on their loans. Eventually it means that the system will collapse completely because the banks will end up with all of the money and all of the assets. Fun for them.

This is why, then, it has been necessary for the Bank of England to hurriedly inject hundreds of billions of pounds into the money supply by buying our government's debt. It's basically giving the government a huge credit card and allowing it to spend new money into the money supply to make up for the fact that the banks aren't creating enough in new loans to keep the system afloat.

Sounds great! Free money for all! Sod taxes, lets just keep the government creating all the free money it needs to pay for unlimited public services. Hurrah.

No.

As banks start lending again and the money supply rapidly increases, inflation will get too high - I don't know, maybe 10% or more wouldn't be unimaginable with all that cash sloshing about. Remember, it's 'real things' that have value, not money, so more money just means that the price of everything goes up.

How will that be fixed?

Massive tax increases and cuts in government spending. The Bank of England will be repaid for all the new money injected into the economy, with interest, from the money supply just like any loan. The rate at which this loan is repaid, and therefore at which we are taxed and services are cut, should mean that the BoE and the gov't can control inflation by sucking money back out of the money supply until we're back at a situation where almost all money is private bank loans - debt, to you and me.

When we get to that point, all the BoE and gov't will have to control the money supply will be interest rates again - making loans cheaper or more expensive as a way of fuelling or dampening our appetite for them.

I believe that inflation comfortably above 2% will still be allowed, however, to devalue the debt faster and, in theory, make the massive borrowing splurge cheaper. The rate of inflation was allowed to soar before the credit crunch hit, too, probably with the same reasoning that the country was shouldering massive amounts of cheap debt (the broken global banking system was resulting in very cheap credit regardless of the BoE's interest rate setting efforts, plus the Labour government ran up huge deficits it couldn't pay for). Unfortunately nothing could have prevented the meltdown that occurred due to scrupulous and, often, stupid international bankers and banks - national monetary policy just isn't enough in a global economy.

It's a diabolical situation. Creating all money as debt, enslaving a society (economic slavery), just bizarre. Yet we allow it. So, as we're being walked all over already, we'd better hope that inflation picks up to reduce our debt (and if you don't think you have any, you do, tens of thousands of pounds, in fact, borrowed on your behalf by our government).