“As long as it is kept within certain limits, inflation is an excellent psychological support of an economic policy which lives on the consumption of capital.” (Ludwig von Mises, Socialism, pp. 448-9)

What causes economic growth? Is it a reduction in tariffs? Is it a cut in tax rates? Is it cutting red tape and bureaucracy? While each might stimulate or encourage economic growth, none of these choices causes growth. Economic growth is the result of an entrepreneur employing a new method that reduces the cost of production. Costs can be reduced in several ways. Newly discovered resources will reduce costs. A new technique that saves time, labor, or resources also reduces costs. And, often overlooked, are the cost reductions, which come from resource allocation according to the law of comparative advantage.

To clarify, suppose that there is an entrepreneur who can make 1,000 units of cloth per day. If this entrepreneur spends $5,000 per day in wages and on maintenance of the capital equipment, then his average cost of production is $5 per unit of cloth. Further suppose that the market price for each unit is $6, leaving the entrepreneur a rate of return of 20% (setting aside other costs and taxes). Now suppose that an improvement in the capital equipment is developed. (The improvement could just as easily have been locating a new source of cotton, an increase in the workers’ skill sets, or an adjustment of production to account for the law of comparative advantage. The important point is that the cost of production falls.) As the cost of production falls, the entrepreneur has a decision to make. He could try to simply pocket the additional profit, but if he does, he is missing out on a much larger gain. If, instead, he lowers his asking price, he will attract customers away from his competitors. His sales will increase, and his revenues will also grow. (When “stealing” customers from other competitors, the demand is “elastic.” Therefore, as the price is lowered, the company’s revenues will increase.)

The business thrives and all the traditional stakeholders win. The workers have become more productive, and as a result, their real wages will rise. Customers can buy more cloth at lower prices. The investors and suppliers are also made better off as the business prospers. Over time, the competitors will have to adopt similar (or better) improvements or face bankruptcy. Society is made better due to the entrepreneur’s reduction in cost.

Economic growth is not homogeneous across the economy. Growth is “lumpy,” because it depends on the amount of cost reductions and in which industries they occur. As a result, the prices of some goods will fall dramatically, while other prices will fall just a little, and a few might increase. The overall aggregate will show price deflation, which is another way of saying that the purchasing power of economic actors will rise. This outcome means that more people have more to spend. They can buy more goods and services, or they can save the new surplus. As prices adjust at the microeconomic level, market disequilibria quickly disappear. As a whole, when the economy grows, we should see a general price deflation.

This conclusion is important because it tells us that there is no economic reason to expand the money supply. Any amount will do. While money is subject to the same rules of supply and demand, like all other economic goods, money is different in one critical aspect. When it is used, it is never used up. In contrast, when I use (consume) an apple, it no longer exists. It gets used up. When I drive my car, it, too, gets used up, albeit at a much slower rate. However, when money is used, it does not get used up. The dollar is precisely the same before and after its use. While the form of money may suffer from some wear and tear, the nominal value of the money unit does not suffer from this degradation. In other words, the spending power of a worn dollar, four new quarters, and a digital dollar in my checking account are exactly equivalent to each other.

Why do some argue that there is a need to increase the money supply? While there is no economic reason to increase the money supply, there is a significant political reason. One could just as easily ask why a criminal counterfeits money. The answer is obvious. He wants to increase his purchasing power at little cost. The same logic is true with the ancient quest of alchemy to turn lead into gold. Regardless of who can create new money, whether it is a criminal counterfeiter, a mystical wizard, or the central bank, the same economic principle applies: those who get the new money first win, and those who get it last, lose. This principle is called the Cantillon Effect, which was first described in the early 1720s. The Cantillon Effect demonstrates that when the new money is first spent, it is exchanged at today’s prices. The new buyer redirects goods and services toward himself by bidding the economic goods away from alternative uses. The bidding for goods and services also raises the prices in those markets.

In this second stage, other people now have the new money. They also spend it, bidding the goods and services away from alternate uses. Again, these actions place upward pressure on prices. Not all prices are affected to the same degree. (It is rare, but some prices might even fall.) Hayek (1969) asks us to imagine honey being poured onto a plate, accumulating in a mound and then slowly spreading outward. However, as the new money spreads throughout the economy, it does not do so uniformly or at the same rate. The analysis must use a step-by-step process because a macroeconomic aggregate analysis will miss the impact of these microeconomic effects. If the new money was injected into a different economic sector or even at a different time, the outcomes would be different. The important point is that some people face higher prices, but do not yet have access to the new money. As a result, their real wealth falls. Thus, the Cantillon Effect shows how those who get the new money first are the winners. And it also shows how those who get the new money last lose. Wealth is transferred from those who get the money last to those who get the money first.

In our economy, who is the first to use new money? Today, our money is not backed by anything. It is created from nothing. Fiat money literally means “money that is declared,” that it is spoken into existence. While we do not need magical incantations to turn lead into gold, we can create unlimited amounts of new money through computer keystrokes at the central bank and the banking system. The central bank of the US, the Federal Reserve System, caters to the federal government’s fiscal policy and the financial and banking system. These institutions receive the new money first. They gain at the expense of everyone else. Each new dollar diminishes the purchasing power of all other dollars. Everyone else’s wealth dissolves. Yes, indeed, there is a reason to expand the money supply. And there is a reason to convince the public that an inflation rate of 3% is better than 2%. Unfortunately, the reason is not a good one, unless, of course, you are a part of the small group that gets the new money first.

The Cantillon Effect demonstrates the short-term impact of monetary expansion. If, as I detail in my forthcoming book, monetary expansion persists, it leads to a business cycle. The long-run consequence of expansionist monetary policies is a reduction in savings, capital consumption, a lower future standard of living, and possibly the breakdown of the currency itself.

Writes Mises:

Inflation is a policy. And a policy can be changed. Therefore, there is no reason to give in to inflation. If one regards inflation as an evil, then one has to stop inflating. One has to balance the budget of the government. Of course, public opinion must support this; the intellectuals must help the people to understand. Given the support of public opinion, it is certainly possible for the people’s elected representatives to abandon the policy of inflation.”