GDP and Inflation

Money matters, monumentally - Part four: transferring wealth

Sunday February 25, 2018 Konrad Hurren

In our last article we briefly covered how Fractional reserve Banking (FRB) works to result in an increased money supply – inflation. The current article looks at how this inflation results in higher prices of goods and how it acts to transfer wealth.

 

Some schools of economic thought treat inflation as an afterthought with an almost “meh, who cares” attitude; usually assuming (not deriving!) that the new money is neutral. Quite the assumption, expedient for the inflation-desirers but disastrous for everyone else. Here we drop such an assumption.

 

Inflation is a transfer of wealth

 

To start this story, assume that sometime in the past some people produced New Zealand’s favourite good, a house, sold it and deposited their money with a bank called Wend in long term deposit agreements (payable by 2050). [1]

 

World of no FRB, no inflation

 

Burrough wishes to take out a loan from Wend (a bank) to buy a house, for $6,000. They draw up an agreement and Wend’s balance sheet now looks something like:

 

Debit (asset) side: IOU from Burrough (due 2020) $6,000

 

Credit (liabilities): accounts payable to depositors (due 2050) $6,000

 

As we see, in a world without FRB Wend can only loan out money that depositors have put in previously. Were Wend to engage in the fraudulent practise of loaning out the cash deposits of her customers (that are available on-call) she would soon find herself the victim of a ruinous bank run, or suffer losses from being forced to sell assets or pay ever higher interest when time comes to clear the cheques with other banks.

 

Burrough then goes to market, finds a house he likes, and purchases it. All is well, Burrough has his house, Wend charges him interest on the loan. Depositors will be paid back in 2050 (or the deposit converted to on-call).

 

We can repeat this process many times with multiple Burroughs (to account for the dynamism of an economy) and find the world still looking rather rosy.

 

Real world, FRB, inflation

 

Burrough again takes out a loan from Wend identical to above. However, this time, Wend knows she is permitted to engage in FRB, because there exists a central bank which will act to subvert the market’s tendency to punish FRB.

 

The two draw up the same agreement, however this time Wend creates Burrough’s loan “out of thin air”. Wend’s balance sheet:

 

Debit (asset) side: Cash ($6,000) + IOU from Burrough (due 2020) $6,000

 

Credit (liabilities): accounts payable to depositors (due 2050) $6,000 + notes of promise $6,000

 

Burrough goes to market, and offers to buy a house for $6,000. All looks okay. The next Burrough to come along sees that the state of the world is such that there are $12,000 of stuff and he bases his consumption decisions on this. Perhaps he calculates that his offer for the house should be $7,000.[2] When we start repeating this process we find that each successive Burrough will receive more and more money “out of thin air” and bid up the price of the house.

 

Fast forward to 2050, successive Burroughs have received much money “out of thin air” from Wend. The wealth producers who deposited the original $6,000 are repaid. They go to market and find, to their horror that the price of the house has been bid up far above the amount of wealth they had originally produced.

 

And so, in a very stylized story we can see that each successive Burrough, receives the new money “out of thin air” in enjoys a transfer of wealth from the original wealth producers to himself.

 

It’s not just houses – inflation and inequality

 

We have purposely pointed out the increase in prices of houses, but the same can be said of all non-cash assets. The owners of these goods enjoy inflation to the extent that money “out of thin air” bids up the price of these non-cash assets.

 

Also in the current configuration of the world, some wealth producers are small savers without significant non-cash assets – or they’re relatively young and have not yet built a pile of non-cash assets. The usual term for people without significant non-cash assets is “the poor”.

 

Inflation then, acts to transfer wealth from the poor and the young to the first receivers of the new money. The first receivers are of course the banks because they are the creators of the new money. Then The State (as the largest borrower, and the only one with a coercive power to tax) as well as those who already have non-cash assets. To the extent that The State is a first receiver of new money and enjoys a transfer of wealth, this transfer of wealth is economically identical to a tax. One that falls disproportionately on “the poor”.

 

Economics is not ethics, we cannot make a judgement on the “goodness” or “badness” of this configuration. But we can point such a configuration out explicitly to inform conversation by people permitted to make ethical judgements.

 

The perniciousness of FRB and inflation go even further, in our next article we describe what happens when a loan is paid off under FRB.

 

 


[1] One can easily replace the house with generic “goods” in this story, but calling it a house serves to shed light on that particular market in NZ.
 
 

[2] This is the gist of how inflation begets price increases – people plan based only on what they can observe, how are they to know half of the $12,000 they can see does not represent real wealth.