GDP and Inflation

Money Matters, Monumentally - Part Five

Monday April 30, 2018 Konrad Hurren

Part five: the conundrum of consuming copious amounts of capital

In our last article we briefly described how Fractional Reserve Banking (FRB) works to increase the money supply and thus to push up prices of goods and services which is how inflation acts as a transfer of wealth. Now, we turn to something more insidious – consumption of capital.


First, some introspection. Would you, dear reader prefer to receive $100 today, or would you prefer to receive $120 next year (on the same day of the month)? Your answer to this reveals the ratio of the values of current goods to the values of future goods in your mind. It is this ratio, taken across all the borrowers and savers, which determines the interest rate. As this article will attempt to describe, the attempt to circumvent this reality through inflation has consequences.


Let’s introduce Burrough and Wend back from last article.


World of no FRB, no inflation


Burrough buys a $6,000 house (New Zealand’s favourite good), in cash he earned by producing some stuff in previous periods. Over time, the area near the house becomes more desirable to live in. Perhaps snow started falling more heavily on the nearby mountains to make skiing a viable pastime. And so, Burrough guesses (using the available information) that his house could sell for up to $8,000.[1] Burrough is delighted, he reasons that he actually wishes to remain in his current location and not sell the house. But he recognises that he now has the means to satisfy ends in his ranked order of preferences that he could not before. Burrough decides he wants to go dolphin watching for $1,500.


Maybe Wend would like to loan Burrough $1,500 with a lien on his house as guarantee.


Burrough now has the opportunity to satisfy some ends he could not otherwise. Life is good. Burrough decides to buy a holiday to go dolphin watching. He also reasons that he should retain $500 of “gains” to pay for repairs in future, clever man.


This is the end of the tale in the world of an unhampered market without inflation. Burrough’s decision was based on sound accounting. He could be wrong, and his house may still only be worth $6,000 but such a risk has already been accounted for, in the ratio between the value of present and future goods described earlier.


Our world, FRB, inflation


Burrough again buys a $6,000 house using his savings. Over time, the area improves in exactly the same way as previously. However, because now we are examining a world of FRB and inflation we must recognise the process described in the previous article. Whereby successive Burroughs continue to borrow money “from thin air” and push up the prices of goods in the economy.[2]


So, in this scenario, Burrough again uses the available information, along with guessing, and estimates that the amount of money someone might offer for his house is $9,000. He is ecstatic and immediately contacts Wend, gives her a lien on his house, and obtains a loan for $2,500 to go dolphin watching. This time he again leaves $500 of “gains” for repairs in future.


Nothing’s wrong yet.


Some time passes: the central bank in Burrough’s country decides that today is the day for interest rates to increase! The central bank tells Wend that overnight loans she uses to clear cheques between her and other banks will incur a higher rate of interest.


Wend reacts to this, and demands less money in overnight loans, implying of course that she lends out less money “out of thin air”.


The inflation (properly identified as an increase in the money supply) slows down, other Burroughs no longer borrow more and more money “out of thin air” (as in the previous article). It is revealed to Burrough that the amount of money someone will offer for his house is now $8,000 instead of $9,000.


But Burrough borrowed $2,500 thinking he’d retain a $500 fund for repairs. This is revealed to be erroneous. Burrough’s house suffers depreciation. It is now obvious to Burrough that he has consumed capital.


Further thoughts


Were it possible to determine precisely the amount of capital consumed this would be a powerful number to show to policymakers, and would probably end the practise of FRB on the spot. However, such a thing is beyond the ability of any human to calculate.


In the next article we will run over the concept of how inflation leads to malinvestment. Before getting into some data/facts to assess what sort of storm clouds might be amassing over the global economy.[3]


[1] Maybe he contacts a professional appraiser. In any case he makes some sort of assessment

[2] This does not imply markets are perfect in any sense. However any deviation implies arbitrage opportunities for risk free profit. So the tendency toward this result exists.

[3] Wend is all too happy with this, she is able to earn interest on money that doesn’t really exist!