JEDDAH, 27 September 2004 — To appreciate the disruptive nature of inflation in its full extent we must keep in mind that it springs from a violation of the fundamental rules of society. Inflation is what happens when central banks increase the money supply at their own will, without any constraints none whatsoever. It produces three characteristic consequences: (1) it benefits governments at the expense of the citizens (2) it allows the accumulation of debt beyond the level debts could reach on the free market; and (3) it reduces the purchasing value of currencies.
The inflation-sponsored centralization of power turns the average citizen more and more into an isolated social atom. All of his social bonds are controlled by the central state, which also provides most of the services that formerly were provided by other social entities such as family.
Fiat inflation has a profound impact on corporate finance. It makes debts cheaper than they would be on a free market. This prompts entrepreneurs to finance their ventures to a greater extent than otherwise through credits, rather than through equity (the capital brought into the firm by its owners).
In a natural system of money production, banks would grant credit only as financial intermediaries. That is, they could lend out only those sums of money that they had either saved themselves or which other people had saved and then lent to the banks. The bankers would of course be free to grant credits under any terms (interest and duration) they like; but it would be suicidal for them to offer better terms than those that their own creditors had granted them. For example, if a bank receives a credit at 3 percent, it would be suicidal for it to lend this money at 1 percent. It follows that on a free market, profitable banking is constrained within fairly narrow limits, which in turn is determined by the savers. It is not possible for a bank to stay in business and to offer better terms than the savers who are most ready to part with their money for some time.
But fractional-reserve banking system (as practiced by all central banks) can do precisely that. Since they can produce additional banknotes at virtually zero cost, they can grant credit at rates that are lower than the rates that would otherwise have prevailed. And the beneficiaries will therefore finance some ventures through debts that they would otherwise have financed with their own money, or which they would not have started at all. Paper money has very much the same effect, but in a far greater dimension. A paper money producer can grant credits to virtually any extent and at virtually any terms. In the past few years, the Bank of Japan has offered credits at 0 percent interest, and it right now proceeds in some cases to actually pay people for taking its credits.
It is obvious that few firms can afford to resist such offers. Competition is fierce in most industries, and the firms must seek to use the best terms available, otherwise they lose that “competitive edge” that can be decisive for profits and also for mere survival. It follows that fiat inflation makes business more dependent on banks than they otherwise would be. The entrepreneur who operates with 10 percent equity and 90 percent debts is not really an entrepreneur anymore. His creditors (usually bankers) are the true entrepreneurs who make all essential decisions.
Because credits springing from fiat inflation provide an easy financial edge, they have the tendency to encourage reckless behavior by the chief executives. This is especially the case with managers of large corporations who have easy access to the capital markets.
Fiat inflation provides easy credits not only to governments and firms, but also to private persons. The mere fact that such credits are offered at all incites some people to go into debt who would otherwise have chosen not to do so. But easy credits become nearly irresistible in connection with another typical consequence of inflation, namely, the constantly rising price level.
Whereas in former times the increase of prices has been barely noticeable, in our day all citizens of the world are aware of the phenomenon. In countries such as Turkey or Brazil, where prices increase at annual rates of 80 to 100 percent. Such conditions impose a heavy penalty on cash savings. In the old days, saving was typically done in the form of hoarding gold and silver coins which was an effective form of saving. Their purchasing power did not just evaporate in a few decades, and in times of economic growth they even gained some purchasing power.
Now compare this old-time scenario with our present situation. It would be completely pointless in our day to hoard dollar or euro to prepare for retirement. A man in his thirties who plans to retire thirty years from today, needs to save three dollars today to have the purchasing power of one of these present-day dollars when he retires.
It follows that the rational saving strategy for him is to go into debt in order to buy assets the price of which will increase with the inflation. This is exactly what happens today in most countries.
As soon as young people have a job and thus a halfway stable source of revenue, they take a credit to buy a car, furniture, house, etc., whereas their great-grandfather might still have first accumulated savings for some thirty years and then bought his house in cash.
It is clear that this state of affairs is very beneficial for those who derive their living from the financial markets. Stockbrokers, bond dealers, banks, and other “players” have reason to be thankful for the constant decline of money’s purchasing power under fiat inflation. But is this state of affairs also beneficial for the average citizen? In a certain sense, his debts and increased investment in the financial markets are beneficial for him, given our present inflationary regime.
The presence of central banks and paper money make debt-based financial strategies more attractive than strategies based on prior savings. It is not an exaggeration to say that, through their monetary policy, most governments have pushed their citizens into a state of financial dependency unknown to any previous generation.
Fiat inflation constantly reduces the purchasing power of money. To some extent, it is possible for people to protect their savings against this trend, but this requires thorough financial knowledge, the time to constantly supervise one’s investments, and a good dose of luck. People who lack one of these ingredients are likely to lose a substantial part of their assets. The savings of a lifetime often vanish in thin air during the last few years spent in retirement. The consequence is despair and the eradication of moral and social standards
Similarly, people will tend to prolong the phase of their life in which they strive to earn money. And they will place relatively greater emphasis on monetary returns than on any other criterion for choosing their profession. For example, some of those who would rather be inclined to agriculture will nevertheless seek an industrial employment because the latter offers greater long-run monetary returns. And more people will accept employment far from home, because it allows them to earn just some little extra money, than under a natural monetary system.
The family in its traditional sense, is the most important “producer” of a certain type of morals, it is the manufacturing factory of responsible human beings, our future generations. Family life is possible only if all members endorse norms such as the legitimacy of authority, the heterosexual union between man and woman, and the prohibition of incest. And all families are based on additional norms such as the love of the spouses for one another and for their offspring, the respect of children for their parents etc. Parents constantly repeat, emphasize, and live these norms.
Today the current system of all governments provides a great number of services that in former times were provided by families. Education of the young, care for the elderly and the sick, assistance in times of emergencies-all of these services are today effectively “outsourced” to governments. The families have been degraded into small production units that share utility bills, cars, refrigerators.
—Abdelmenem Jamil Addas [email protected]
Professor of Financial Markets, College of Business Administration, Jeddah.
