Two-Digit Inflation; H. Sennholz

But such lessons cannot be learned as long as ignorance deprives man of some basic understanding of his affliction and of the .remedies there are. For hundreds of years the is sue of excessive quantities of pa per currency by government was called inflation. Rising goods prices were deemed to result in evitably from such issues and were thought to offer an indica tion or measure of the degree of Dr. Sennholz heads the Department of Eco nomics at Grove City College and is a noted writer and lecturer on monetary and economic affairs. Inflation monetary inflation. But in the semantic confusion of our age we are calling the rise in prices in flation. And the issuer of the money, spendthrift government, is called. "inflation fighter." How delightful and profitable for officials and politicians! They can spend and spend without much worry about budget deficits, which are covered by the issue of new currency. The new terminology implicitly lays the blame for ris ing prices on anyone who dares to raise his prices, on "greedy" busi nessmen and workers, speculators and foreigners. But the confusion brings havoc and poverty to count less victims whose incomes are greatly reduced and savings de stroyed. It impoverishes the "mid dle class" with its savings for the rainy day and retirement.

Inflation is sometimes described as a tax on ,the money holders. In reality, it is a terrible instrument 23 24 THE FREEMAN Janua,r-y for the redistribution of wealth. It is true, the government is prob ably its greatest profiteer as its tax revenues are boosted by the built-in progression in higher in come brackets and through the de preciation of governmental debt. But in addition, the inflation shifts wealth from those classes of society who are unable, or do not know how to defend them selves from the monetary destruc tion, to entrepreneurs and owners of material me'ans of production. It strengthens the position of some businessmen while it lowers the real wages of most working men and professionals. It decimates or destroys altogether the middle class of investors who own secur ities or hold claims to life insur ance and pension payments. And finally, it gives birth to a new middle class of traders, specula tors, and small profiteers of the monetary depreciation.

Massive Redistribution The magnitude of the present redistributive process in the U.S. can only be surmised. Let us esti mate the total volume of public and private debt at $2.7 trillion (Federal $475 billion, state and local government $200 billion, corporations $1150 billion, farms $80 billion, residential mortgages $400 billion, commercial mort gages $75 billion, other commercial debt $55 billion, financial debt $65 billion, consumer debt $195 billion). A ten per cent rate of dollar depreciation transfers $270 billion a year from the creditors to the debtors. A fifteen per cent rate, which better reflects econom ic reality, would transfer $405 billion per year. Now, disposable personal income in the U.S. is esti mated at $931 billion (cf. Federal Reserve Bulletin, July 1974, p. 57), which makes the inflation transfer income and loss nearly 44 per cent of annual incomes from productive services. In short, present inflation as a powerful in strument of wealth redistribution is responsible for a stream of in come and loss equal to almost one half of our productive efforts.

The redistribution process is also a massive debt liquidation process in real terms. Surely, the nominal magnitude of dollar debt is rising, but in terms of real things and real values debt is be ing liquidated at the depreciation rate. A ten per cent rate of cur rency depreciation reduces real debt by ten per cent; total mone tary destruction destroys debt to tally. It transfers the ownership of real wealth from the people who have lent money to the people who have borrowed the money. Such are the profits and losses from only one source: the cur rency depreciation that gives to 1975 TWO-DIGIT INFLATION 25 debtors that which it takes from creditors. In addition, several other inflation factors inflict huge losses on nearly all classes of so ciety. Rampant inflation destroys the capital markets which are the very well-spring of productive enter prise. Having suffered staggering losses through depreciation, few lenders are able to grant new loans to finance business expansion or moderniza tion, or merely current operation. And even if they had the funds, they are reluctant to enter monetary contracts for any length of time. Business capital, especially long-term loan capital, becomes very scarce, which precip itates economic stagnation and recession. Similarly, businessmen begin to hedge for survival, in vesting their working capital in inventory and capital goods.

Funds that used to serve con sumers become fixed investments in capital goods that may escape the monetary depreciation. Eco nomic output, especially for con sumers, thus tends to decline, which may raise goods prices even further. A great deal of "unproductive" labor is needed to cope with the complexities of calculation and dealing with rapidly changing prices. Cost accounting faces the insoluble task of calculating busi ness costs with a yardstick that is shrinking continually. Managerial decisions become very difficult and enterprise e·fficiency is greatly hampered, which raises business costs and reduces output. Finally, the greatest danger to economic production and well-be ing looms in sudden government intervention. Having recklessly depreciated the currency at two digit rates, the same government may want to legislate and regu late the economic actions of the people. It may suddenly impose price, wage, and rent controls, re strict imports or exports, levy new taxes, or commit some other folly, all in order to treat some symp toms of its own policies.

Real Wages Fall Two-digit inflation tends to re duce the real wages of nearly all classes of employees" from un skilled laborers to chief executives. While many goods prices can be adjusted quickly to the monetary depreciation, wage and salary con tracts are written for longer peri ods of time, .often for a year or even longer. During this time' em ployees suffer a continuous ero sion of real incomes and stand ards of living. It is true, the re duction in real wages, which are business costs, tends to raise the demand for labor, which generally causes unemployment to decline. Also, profitable· enterprises that 26 THE FREEMAN January continue to compete aggressively for labor tend to review wages and salaries more often than be fore, for instance, every six months instead of waiting two years. Others boost merit pay sub stantially to avoid rising costs through higher turnover. The general decline in real wages tends to breed widespread labor unrest. Individual productiv ity may fall substantially which raises business costs, reduces out put and thus boosts prices even further. Labor unions react by demanding large increases in nom inal wages, and sometimes may succeed in restoring real wages at least temporarily, until the infla tion again reduces real wages,. fol· lowed by further union demands, and so on. Ugly strikes multiply, costing millions in work hours, in flicting business losses and raising costs, and thus generating ever greater pressures for higher prices. In desperation many mil lions of heretofore unorganized employees are led to joining un ions or forming collective strike organizations in order to avert the loss of real wages. Labor un ions seem to thrive on monetary depreciation and the economic con flict it generates.

Rampant inflation also affords growing popularity and public support of a system of wages based on a cost-of-living index, commonly called indexation. All wages may be fixed according to an' index number calculated by a govern ment bureau. Of course, even such a system cannot be expected to protect labor from the disastrous influences of monetary deprecia tion as the index is calculated on the basis of past prices that differ from goods prices when wages are paid and spent. General indexa tion of wages also works havoc upon those industries that suffer severely from the inflation, such as consumers' goods industries and service industries. They may contract further, reducing output and service, which again raises prices. The Poor Suffer The poorest classes of society living closest to the subsistence minimum are hurt most severely by monetary depreciation. Espe cially those poor who live on fixed incomes, such as pensions and an nuities or welfare gratuities that are slow to adj ust to the rise in prices, may actually experience deprivation and hunger. Others may be forced to supplement their shrinking purchasing power by seeking employment if this should be possible. Thus, some unskilled labor that used to prefer public support over .working for a living vlill return to productive employ ment. Others may resort to vice 1975 TWO-DIGIT INFLATION 27 and crime to bolster their falling incomes.

Real incomes of civil servants, military personnel, and salaried employees of commerce and in dustry may fall even faster than those of the poor. True, they may not immediately face deprivation and hunger, but they may be greatly reduced and impoverished by the rise in goods prices that tends to exceed their occasional salary adj ustments. The situation may even be worse with professional men, such as physicians and dentists, attorneys, artists, writers, and professors at private institutions of learning. Rampant inflation may red uce them to a life of penury and mis ery as public demand for their professional services tends to de cline significantly with the gen eral impoverishment of the popu lace. After all, demand for their services is much more elastic than that for food, for instance, which explains why less money is spent on professional services in spite of ever larger governmenf expen ditures on health, education and welfare.

The suffering of this profes sional class is compounded by the destruction of its savings through infl.ation. In general, the middle class generates the financial capi tal that affords productivity and expansion to commerce and industry. It holds a large share of national wealth in the form of financial capital, such as corporate stock and debentures, demand and time deposits, life insurance, pen sion funds, and the like, all of which suffer serious losses from the depreciation of the currency. In fact, rampant inflation expro priates the wealth and substance of this middle class. Dangerous Stock Markets The stock market offers great opportunities during periods of rampant inflation. Industrial shares especially are subject to ex treme fluctuations in price, ,which astute traders will use to their ad vantage. This does not mean that the market offers investors a re liable hedge against inflation. On the contrary, the real value of shares tends to decline, which in flicts considerable depreciation losses on share owners. But alert traders can profit from the many chills and fevers that attack the market.

The greatest factor of change that virtually shapes the price trends is the monetary policy of government. Large bursts of mon ey creation and credit expansion are followed by sudden jerks of restraint or even stability, which trigger symptoms of economic re cession and decline. Or, the gov ernment may suddenly impose 28 THE FREEMAN January price, wage and rent controls, or resort to other means of inter vention that temporarily reverse the trend. To ignore the ever changing signals of monetary pol icy and other government inter vention can be very costly. In terms of purchasing power, stock prices tend to decline be cause most business profits are more apparent than real. The sums set aside for maintenance· of equipment, called depreciation, are mostly insufficient. Replacement costs soar while depreciation that is allowable under the tax laws is based on past costs and therefore insufficient to cover present costs.

In fact, many profits are fictitious, which causes companies to pay in come taxes although there is no income, and declare dividends while working at a loss. Similarly, the inflation profits on inventory are mostly fictitious as replacement costs may equal or even exceed the proceeds of a sale that was be lieved to be profitable. During periods of rampant in flation it is very difficult, even for experts, to ascertain the profit ability of an enterprise. To in terpret profit statements and bal ance she'ets becomes nearly im possible, which affords companies an opportunity to hide their earnings or losses and show only what they want to show. For an investor to appraise the value of his corporate shares becomes an insoluble task. Occasionally the monetary au thorities may slow down or even abstain from creating more cur rency and credit. Or their rate of expansion may fall short of that expected by businessmen. In each case the fevers of inflation are in terspersed with the chills of re cession and depression, which send stock and bond prices tum bling until, once again, the Fed eral Government comes to the res cue with record budget deficits and new bursts of currency ex pansion. After all, this is the basic recipe of the "new economics" that has shaped Federal economic pol icy since the 1930's and has given us "inflationary recessions," i.e., simultaneous inflation and reces sion.

No Sure Hedge in Fluctuating Stocks When one or several of the stated factors depress stock prices the public may realize that even the purchase of industrial securi ties affords no safe means of in vesting their savings. Suffering heavy losses, they withdraw from the market and invest their re maining funds in goods or money market instruments, especially Treasury obligations. The public is the "middle class" of some 30 million stockholders and 50 mil1975 TWO-DIGIT INFLATION 29 lion investors who indirectly own corporate securities through in vestment companies, pension funds, life insurance companies, credit unions, and so on. They suffer heavy losses when they finally liquidate their stock investments for depreciated currency . It has been estimated that since 1965 most American stock investors have lost at least 40 per cent of their savings through price de clines and another 40 per cent through currency depreciation.

From time to time, the fever of inflation may cause stock prices to soar as the monetary authori ties refuel the money markets in order to avoid depression and un employment. The investor may re joice about his long-awaited prof its. Deluded by the apparently high prices he may be induced to sell his securities. Unfortunately he may not be aware of the, real losses which the monetary depre ciation is inflicting on him. Again he loses severely in purchasing power and real wealth, and yet may have to pay an income tax on the nominal profits he earned. The speculator who observes the merciless drubbing of most in vestors has learned to distinguish "apparent profits" from "real" ones. He trades with the trends of the market, jumps from industry to industry, always seeking action and quick profits. But above all, basically he is a buyer of the se curities that are liquidated by the middle-class investor. The mone tary depreciation which greatly red uces their real price makes it easier to acquire securities. Thus, 'we can observe not only a gradual shift of corporate wealth from the old class of capitalists and middle class investors, but also a concen tration of industrial shares in fewer and fewer hands. A small new middle class of traders and speculators replaces the old mid dle class of investors, and huge new fortunes are created from the losses suffered by investors and capitalists.

The 'depreciation of public debt and the fall of industrial securi ties in terms of both price and purchasing power strike a devas tating blow not only at millions of small investors but also at great capitalists whose wealth is in vested in marketable securities. Wealthy stock brokers, bankers, financiers, rentiers, heirs, or busi nessmen in retirement who before the inflation owned large fortunes, that is the "old rich," suffer seri ous losses. Old fortunes vanish, and eminent family names fade away. Similarly, the wealth of charitable institutions, religious societies, scientific or litera.ry foundations, and endowed colleges and universities, is destroyed by inflation.

30 THE FREEMAN January Losses in Real Estate While inflation inflicts havoc on monetary investments, it has var ied effects on property of land and buildings. Agriculture, on the whole, survives a period of fever ish inflation rather well. Farmers generally profit from the increase in prices of agricultural goods and from the depreciation of farm mortgages. Even small and mid dle-size operators whose debt may render their independence rather precarious in normal times can hold their own during rampant inflation. After all, they are the producers and owners of real goods the prices of which rise, yielding ever higher incomes, while inflation reduces the real burden of their debt. Ownership of residential hous ing offers a much poorer defense against inflation than is common ly believed. Although mortgage debt is greatly reduced by the in flation, which affords some infla tion profits to owners, the market price of private residences and commercial property usually limps behind the rate of monetary de preciation. During rampant infla tion interest rates soar and mort gage loans are hard to find, which makes it rather difficult to finance a purchase. Thus, effective demand may be reduced which tends to depress real estate prices. This is especially true for middle class housing whose owners feel im poverished and in need of re trenchment.. It may not be true for beautiful mansions and large estates that continue to sell at high· prices to a new class of nouvea,ux riches.

But even when real estate appre ciates in price and the owner gains from a sale, on which he must pay a capital gains tax, he may lose in terms of purchasing power. Deluded by apparently high prices, many owners may be in duced to sell their homes, to real ize only much later, perhaps, that they made a poor bargain. The situation is most danger ous and precarious for apartment house owners. They are vulner able not only to the imponderables of a feverish capital market, to the impoverishment of their work ing and middle-class tenants, and to the price delusion mentioned above, but also to the ever-present danger of rent control. A desper ate government may do desper ate things. Drawing wrong con clusions from given facts and fighting symptoms rather than causes, it may by force arrest prices, wages and rents. But rent controls imposed for prolonged periods of inflation reduce real rents significantly, which causes house prices to fall accordingly.

With maintenance expenses ris ing, real rents falling and losses 1975 TWO-DIGIT INFLATION 31 looming, many owners· may be forced to sell out - at very low prices. And again, the class of old investors makes room for a new class of speculators who at bar gain prices are buying a great many houses. But even without controls ren tal property may be depressed be cause working and middle class demand for housing is shrinking as real income is declining. Or, many apartment house owners may not realize the significance of the monetary depreciation, and therefore are slow to adjust their rents. Or, they may be reluctant to raise rents for charitable rea sons. In each case the yield from such property tends to decline, and therefore also real estate prices, which may inflict serious losses on its owners. The Nouveaux Riches Huge private fortunes and im posing concentrations of capital are formed from inflationary re distribution. But in contrast to the formation of .capital under stable monetary conditions, when fortunes are built through pro d uctive changes and improve ments, through technological in ventions and efficient methods of production, the wealth derived from inflation is "redistributive,"

from one individual to another. The new millionaires are not generally creators of new industries or reorganizers of production. They are mostly clever speculat ors with excellent understanding of monetary policy and its effects on stock prices, exchange rates and high finance. They may even be industrialists who are turning away from the hard work of business management to the more rewarding dealings in securities, commodities and foreign exchange. But above all, they understand the phenomenon of inflation and use this knowledge in all their finan cial operations. As speculators they endeavor to render the most urgent eco nomic service needed at the time. They are quick to adj ust their resources to the, rapid changes in prices and markets that suffer from chronic maladjustments due to the ever-changing monetary scene. Thus they facilitate quicker and smoother readj ustment and better allocation of economic re sources to the most urgent needs of the, public.

During rampant inflation one of the rules of good management is to contract as many productive debts as possible. The speculator borrows other people's money, which is repaid later with depre ciated currency. Instead of keep ing large bank deposits he finds it more advantageous to incur the highest possible debt with his 32 THE FREEMAN January bank. Of course, at all times he must maintain his liquidity to meet current obligations, always guarding against sudden calling of loans by his bank in moments of extreme credit stringency. Inflation not only destroys in come and wealth, but also redis tributes them from millions of creditors to many debtors. Some businessmen, especially the young, aggressive entrepreneurs, under stand this principle and utilize it to their advantage. They expand their enterprises or acquire new ones, merge with others or form new business structures - always building on debt. The inflation losses suffered by banks and bond holders who finance the expansion accrue as profits to these entre preneurs who join the class of nouveaux riches. But occasionally when the government reverses its monetary policy, when it deflates rather than inflates or when it merely reduces the rate of mone tary depreciation, these entrepre neurs may find themselves overex tended. They may have to contract their operations, or liquidate some of their holdings. In fact, some may lose their fortunes even faster than they were made.

Chills and Fevers Financial survival is especially difficult as the fevers of inflation are interspersed with the chills of recession. Some industries may be seized by the inflation fever while others may suffer recession symptoms. Rampant two-digit in flation does not follow the simple pattern of earlier moderate in flation, which tends to generate economic booms that are followed by periods of recession. Instead, it causes such serious disarrange ment of markets and disruption of production that both economic disorders occur simultaneously. The rapid depreciation of the money virtually destroys the cap ital market. The supply of loan funds tends to shrink as lenders are fearful of suffering losses from the depreciation of the money. Capital-intensive indus tries and others that depend on long-term financing, therefore lack the necessary capital for ex pansion, modernization, or merely maintenance of costly capital equipment. The strength and sub stance of such industries may de teriorate, their capital being grad ually consumed. If, in addition, these industries are enmeshed in government rate setting and price fixing, they may wear out quickly, which becomes visible in the de terioration or even breakdown of service. Obviously, the equity mar kets of these industries tend to be depressed throughout the ram pant inflation.

Also consumers goods indus1975 TWO-DIGIT INFLATION 33 tries, in general, tend to contract throughout this period. After all, most consumers suffer losses of income and wealth and, therefore, are compelled to curtail the con sumption of goods they deem least essential. Vacations may be post poned or at least shortened. Ex penditures on entertainment, amusement, and other "luxuries" may be cut. There may even be reductions in the quality of essen tials, such as food, clothing, and housing. And instead of seeking education in. private institutions, the children may attend public schools, and state or community colleges. The only industries that thrive on rampant inflation are the cap ital goods industries. They are producing the goods that permit business to hedge against the in flation through investments in ne·w tools and equipment, or larger inventories of materials and sup plies. As inflation reduces the real costs of labor, many busi nesses endeavor to accumulate capital in the form of durable assets, preferably those that are expected to appreciate in value \vhile retaining some degree of marketability. Many companies use their own working capital or seek bank loans to increase their inventories or add to tools and equipment, which can be expected to rise. faster in price than the interest costs on the capital in vested. They sacrifice liquidity in the hope of higher profits from the expected rise in prices.

Boom and Bust All these specific symptoms of rampant inflation tend to conceal the most important predicament that affects everyone: the boom and bust cycle that is generated by the inflation. When the mone tary authorities first expand the money supply in order to finance Federal deficit spending or stimu late the economy they set into motion certain forces that seri ously distort the allocation of pro ductive resources. Specifically, the policy of easy money and credit temporarily reduces interest rates, which causes businessmen to in vest more funds in. new construc tion, machinery, equipment, and raw materials. It generates a fe verish boom in the capital goods industries with rapidly rising prices of labor and resources. Now, this boom built on easy money and credit must come to an end as soon as the rising prices of labor and resources, which are business costs, erase profit mar gins or even inflict losses. After all, the boom must end as it was artificially built on paper and credit only. The' recession that follows permits markets to return to normal, in particular, capital 34 THE FREEMAN January goods prices to decline, the in dustry to contract again, and the consumers goods industries, which were neglected throughout the boom, to come into their own again.

But this cycle· can be extended in duration and be made more severe in its fluctuations through new inj ections of money and credit. Or merely the anticipation of new injections may cause bus inessmen to reduce their cash holdings and escape into real goods. Thus, the boom may con tinue to rage even though the mon etary authorities may cease tem porarily to add new, money and credit, because businessmen have come to expect an early resump tion of monetary expansion. Once capital goods prices rise at two digit rates, a temporary halt in the expansion process does not signal an end of the boom that continues to be fed by business men's reduction in cashholdings. Although interest rates may soar and the costs of financing equip ment and inventory rise signif icantly, capital goods prices are rising even greater. It pays to order and buy now rather than wait until prices have risen again.

The expectation of an early re sumption of easy money and credit that keeps the fires of boom burn ing is solidly based on a political assumption: that government will soon inflate again in order to al leviate some consequences of its earlier inflation. Alarmed about the recession that is engulfing the consumers' goods industries, it will want to stimulate once again these industries. When consumers are fast losing purchasing power during two-digit inflation, con sumers' goods industries suffer symptoms of contraction and re cession, especially unemployment of capital and labor. But by pop ular demand government is ex pected to cope with. this recession with all means at its disposal. That is, it is expected to resume deficit spending and credit ex pansion in order to restore full employment. The economic boom thus burns on with new money and credit. From Bad to Worse In the ideological climate of today there can be no genuine re versal of monetary policy. The two-digit· inflation must ra.ge on, feeding an ever hotter boom of the capital goods industries and aggravating the recession in the consumers' goods industries. The purchasing power of the dollar must fall at ever faster rates, being depreciated by ever larger injections of money and credit and a growing expectation thereof.

Two-digit inflation only comes to an end with the advent of three1975 TWO-DIGIT INFLATION 35 digit inflation which signals the approaching demise of the paper currency. In the final convulsion, of inflation fever, millions of housewives join businessmen in a panic rush to exchange their rap idly depreciating money for real goods. 'Vhen millions of consum ers hurry to spend their monetary assets and use all their lines of credit in order to seek refuge in real goods, the end of the cur rency comes in sight. Consumers' goods prices that were rising at much lower rates than those of prod ucers' goods then will soar to catch up with the latter, or even surpass them, in the final contortion of the crack-up boom. In the dusk of the paper system that springs from political power and economic redistribution, the dreaded depression that was so long delayed in coming will finally make its entrance with irresisti ble force. Thus, once again, the inexorable laws of economics will prevail over political intrigue and power.