Thursday, May 24, 2007

Monetary Policy and Inflation (3) - The Culprit

A review of the history of money shows that all serious inflations have been caused by governments. If you go back far enough currency was issued by banks. Often the notes and coins issued by several different banks would be in circulation. However, people did not trust the bankers because they saw them getting rich. So gradually governments took over responsibility for issuing notes and coins. Now in most countries, the government has a legal monopoly over the issuing of currency.

However, this did not solve the problem. Sure banks could inflate their own currency, but this was dangerous, because they could eventually face a run and the bank would be forced out of business. For a bank, it paid to be honest.

Governments do not face this constraint, because they cannot be forced out of business. The history of banking is littered with stories of governments that have inflated the currency of their nation. Initially, the governments turned on the printing presses and printed more banknotes. More recently, they have become more sophisticated and set up a central bank to manage the process. They can then inflate the currency by borrowing issuing securities and selling them to the central bank.

In the modern world, rampant inflation is always caused by the government expanding the money supply. Politicians like inflation, because it allows them to increase their spending without increasing taxation. Big spending politicians are usually to blame.

The worst inflation of during last century was in Germany. During 1922, prices rose by 700 percent. The cause was obvious. 300 paper mills were working top speed and 150 printing companies had 2000 presses going day and night turning out currency order by the government bank. During the following year, prices increased by more than 7000 percent, before the currency collapsed and was replaced.

More recent examples of runaway inflation include Bolivia (1985), Nicaragua (1988), Poland (1989), Brazil (1989 – 90), Peru (1990), Zaire (1990 –94), Russia (1990), Georgia (1992–94) Angola (1994– 97), Argentina (2002), Zimbawe (2006-). In every case, the cause was the government.

No comments: