Now let us again recall the price grid. Prices in it change in response to shifts in supply and demand. In turn, supply and demand reflect any number of factors—an increase or decrease in demand for a particular good, a decline in its stockpiles, technological improvements, and so on. That is, all these prices and their changes reflect real goods and services, the activity of producing and exchanging them, “scientific and technological progress,” and so forth.
What happens when counterfeit money enters this system? As we have just established, money never enters the “system as a whole”—it always “enters” at some specific point and is exchanged there for real goods and services. In general terms, this looks like an increase in demand for goods purchased with this money. All other things being equal, this causes a rise in the price of those goods.
Let us recall that the price before the appearance of counterfeit money reflected a certain allocation of resources, labor, and capital in the economy. A change in this price without counterfeit money would have occurred only when changes occurred in these real economic factors. Suppose, with the same demand, the stockpiles of a certain good decreased—this would cause its price to rise. That price change would become a signal to other producers that it is now profitable to produce this good. They would redirect their available resources toward its production, stockpiles would grow, the price would fall, everyone would be satisfied, and society would become richer.
In our case, none of this happened—counterfeit money was simply added to the system. Yet economic agents are unable to distinguish signals from the real economy from signals caused by counterfeit money: both manifest as price changes, and so they respond as they would to genuine changes. The result is that marginal producers try to produce goods whose demand has not increased and whose stockpiles have not declined.
Keynesians forget that the resources available to the economic system here and now are always limited. This is precisely why prices exist. The price grid shows how resources are currently distributed, and price changes indicate where efforts should be directed so that “the system as a whole” produces more valuable outputs. Adding counterfeit money to the system leads only to a redistribution of resources—and moreover, to an erroneous redistribution. What happens can be illustrated through consumption. In a normal economy, where there is no central bank with its paper notes, my consumption is regulated by other people. To increase it, I must increase the value of what I produce for them. As a result of my efforts, our aggregate wealth grows. In the case of monetary emission, wealth does not grow—it simply moves.
The harm of inflation lies in constantly distorting the economy’s natural adjustment, introducing chaos into it, and generating errors. The economy creates hundreds of billions, if not trillions, of connections, and most of these connections are even unknown to those who participate in them. The most ordinary good is the product of the longest chain of cooperation between interconnected producers. These people do not even need to know of each other’s existence in order to cooperate, since there is exchange—and exchange through an intermediary good, that is, money. Inflation means disorienting people and the senseless destruction of resources. By distorting exchange relations in ways that cannot be traced, inflation makes possible the existence of enterprises that under other conditions would never have appeared. The profits of these enterprises are “provided” by inflation. They benefit no one, yet they consume resources—that is, they take them away from those who could use them more productively.
That plastic world of unnecessary things in which we live, the race of “new models” of goods that are no different from the old ones, the dominance of dreariness and wretchedness in all areas of our life—these have simple financial reasons at their foundation. “By distorting accounting and creating phantom profits, inflation prevents the market from punishing inefficient businesses and rewarding efficient ones. The dominance of the ‘seller’s market’ leads to a deterioration in the quality of goods and services, since it is much easier for the consumer to become accustomed to hidden price increases when the price seems to remain the same while only ’the’ quality declines”—Murray Rothbard writes.
As we said earlier, while inflation always has a harmful effect on the economy, it can be difficult to recognize. Since the “flooding” of money is a sequential process and money moves from one agent to another, the resulting picture depends on the preferences of the people to whom the new money reaches, on where and how they use it. Suppose you are engaged in large-scale import—then you will most likely have to account for currency quotes and inflation. But if you are buying an apartment with cash, then you will most likely boldly send your counterparty wherever he pleases if he starts talking about an “inflation adjustment.” Yet the same money—yet such different behavior…
In general, if it were possible to “flood” the same amount into the same economy twice, we would get two completely different price structures and completely different outcomes for specific participants in the process.
“Changes in the structure of prices caused by changes in the supply of money in the economic system never affect the prices of goods and services to the same degree at the same time. The main error of the old quantity theory of money, as well as of the equation of exchange of mathematical economic theory, was that they ignored this fundamental problem. A change in the supply of money must cause a change in the other variables”—Ludwig von Mises writes.
Consider this: if the “inflation indices,” which are precisely derived from the growth of the “average price level,” actually signified something useful, then there would simply be no inflation, since everyone would multiply their prices by these indices. That is, in reality, we do not know when and where the growth of the money supply affects us, and this means we cannot protect ourselves from it—that it distorts our activities whether we want it to or not. Inflation does not even always manifest itself in price increases. For example, before the Great Depression, there was no observable growth in the “price level,” yet there was rapid growth in the money supply organized by the Fed. This inflation did not result in price increases because there was simultaneous rapid growth in production.