Inflation v Deflation – State Finances

Dec 7, 2017·Alasdair Macleod

There is a general belief, and that is all it is, that state finances fare better in an inflationary environment than a deflationary one. This perception arises from the transfer of wealth from lenders to the state through a devaluation of the currency, which occurs with monetary inflation, compared with the transfer of wealth from the state to its creditors through deflation. The effect is undoubtedly true, even though it is played down by governments, but it ignores what happens to continuing government obligations and finances.

This article looks at this aspect of government finances in the longer term, first on the route to eventual currency collapse which governments create for themselves by ensuring a continuing devaluation of their currencies, and then in a sound money environment with a positive outcome, for which there is good precedent. This is the second article exposing the fallacies of supposed advantages of inflation over deflation, the first being posted here.

Inflationary policies

While central bankers have convinced themselves, in defiance of normal human behaviour, that consumption is only stimulated by the prospect of higher prices, there can be little doubt that the unmentioned sub-text is the supposed benefits to borrowers in industry and for government itself. Furthermore, the purpose of gaining control over interest rates from free markets is to reduce the general level of interest rates paid to lenders, further robbing them of the benefits of making their capital available to willing borrowers.

All this is in defiance of the principles behind contract law, but the courts do not accept that the unbacked state-issued currency of today is no different from the gold-backed money of yesteryear, nor the same as tomorrow’s further debased currency. Tax on interest is an added distortion, reducing net interest received by holders of depreciating currency even more. It is hardly surprising that the savings rate collapses in an economy characterised by inflation and taxed savings, leading to a relentless expansion of debt, financed by other means.

These “other means” are mostly the expansion of bank credit, which is money created simply through book-entry. The cost of creating this money is set by the wholesale money rates, which are in turn set by the banks that issue the credit. If they all expand their bank credit at the same time (and it should be noted that bankers are very susceptible to herd instincts), interest rates can theoretically fall to zero, or more practically, the marginal cost of expanding it, which on large loans is almost the same thing. And as if that is not enough, there is now in addition a combination of central banks rigging interest rates to be negative coupled with quantitative easing, which has even allowed corporate borrowers to be paid to borrow money.

 As already stated, the whole point of monetary inflation is to transfer wealth from lender to borrower. In the government’s case, it is a replacement for taxes that have become so burdensome, that to increase them further either risks provoking a taxpayers’ rebellion, or is so economically damaging that even the state knows to back off. But the books must be balanced, and given the unpalatable alternative of cutting spending, funding through monetary debasement is the accepted solution.

Most central banks understand from experience that if the central bank is involved in funding the government’s spending directly, the currency will eventually descend into crisis. Instead, central banks achieve the same thing by suppressing interest rates and allowing the commercial banks to subscribe for government bonds. They are bought by the banks themselves, or alternatively by lending to others to buy the government’s debt. There are technical monetary differences between bank and public subscriptions for government debt, which must be conceded. Nevertheless, it is just as inflationary, being supported directly or indirectly by the expansion of bank credit, particularly when central banks ensure that total currency in circulation will never be allowed to contract.

An important assumption behind long-term inflation targets, currently set at 2% per annum, is that the general price level can be controlled by managing the money stock. This flies in the face of all experience, and even economic theory. During the Volcker chairmanship of the Fed, when the effective Fed funds rate rose to over 19%, there was no let-up in the growth of broad money. It grew at 6.2% that year, compared with a long-term average annual growth rate of about 5.9%.[i] To link interest rates to the money-quantity is a common mistake by those who do not realise that interest rates regulate not the quantity of money, but its application.

The rate of US monetary expansion was reasonably constant at a little less than 6% until the Lehman crisis, yet interest rates (measured by the effective Fed funds rate) had varied between 19.1% in 1981 and 1% in 2003. US consumer price inflation had also varied between 14.4% and 1.07% on the same time-scale. There is no correlation between the quantity of money and these two statistics at all, so the control mechanisms employed, which are meant to regulate the decline in the currency’s purchasing power, are entirely bogus.

The point was sort of accepted by an official at the Bank of England last week. Richard Sharp, who is on the Bank’s financial stability committee, warned that if the UK Government increased its borrowing, it risked sliding into a Venezuela-style crisis. Undoubtedly, this comment was provoked by a growing debate over Jeremy Corbin’s proposal to borrow an extra £250bn if Labour is elected. But it raises the question over what is the difference between Venezuela’s disastrous inflation policies and those of Britain, other than scale. The answer is simply nothing.

Venezuela’s economic collapse into hyperinflation is all our final destinations as well. It is the eventual destination for all governments that depend on financing themselves by inflation. No longer are deficits being talked about as only temporary. Realistically, the accumulation of welfare liabilities, past, current and future, make it impossible to balance the books from taxation alone.

The fallacy that the state benefits from inflation ignores our central point: it transfers wealth from the masses. Far from stimulating the economy by persuading the masses to spend rather than save, it gradually grinds them down into poverty. The high standards of living in the advanced economies were acquired over decades by ordinary people working to improve their lives. The accumulation of personal wealth is vital for the enjoyment of improved standards of living. Remove earnings and wealth through currency debasement, and people are simply poorer. And if people are poorer, the finances of the state also become unsustainable.

This is why regimes that exploit the expansion of money to the maximum, such as Venezuela and Zimbabwe, demonstrably impoverish their people. It takes little intellect to work this out, yet amazingly, neo-Keynesian economists fail to grasp the point. The most appalling example was Joseph Stiglitz, a Nobel prize-winner no less, who ten years ago praised the economic policies of Hugo Chavez.[ii] Ten years on, we know the result of Chavez’s inflationary follies, which have taken Venezuela and her people into the economic abyss. Despite Stiglitz’s execrable errors, he remains an economist respected by those whose biased analyses are simply to wish reality away.

Economists and commentators fixated on the cheapening of government debt through inflation fail to distinguish between the sustainability of existing and future debt. These wishful thinkers believe that drawing a line under the past will allow governments to finance future obligations as if nothing had happened. They suppose that with a clean national balance sheet, facilitated perhaps by the issue of a platinum coin with a trillion-dollar notional value, everything will be righted. This ridiculous proposition was seriously considered in the wake of the Lehman credit crisis.[iii] It was not contemplated just to put government finances on a better footing, but as a device to permit more government borrowing.

The reality of inflation is what starts as a temporary escape route from constraints on government spending ends up being a trap from which escape becomes progressively more difficult, until it is practically impossible. Inevitably, if the state impoverishes its citizens today by debasing the currency, it will have a larger welfare bill tomorrow. It requires an accelerating rate of currency debasement to keep balancing the books.

The only solution is to halt the expansion of money. Then, to ensure it retains its purchasing power, unlimited convertibility into gold on demand by all-comers must be introduced and enshrined in law, so that no further currency can be issued by the central bank without increasing gold reserves to cover. This currency then technically becomes money-substitutes, the money being gold. Bank credit can either be curtailed by making fractional reserve banking punishable as fraud (which it was in times past, and without a banking licence, still is), or alternatively ensuring there is a discernible difference between balances credited to depositors, and the money substitutes issued by the central bank and covered by gold. Furthermore, all bank bailouts and bail-ins must cease, again by law, despite the consequences. Deposit protection must also be removed.

The reliance on regulation to control bank excesses is a mistake. Banks must be entirely customer focused, and not driven by regulation. Only then, will bankers understand that enhancing their public reputation is what keeps them in business. Unwise speculation by the bankers in the knowledge the central bank will always bail them out will cease. A split will naturally emerge between loans financed by bank deposits (mostly working capital, trade finance and similarly secure short-term liquidity requirements), and more risky loans, properly financed by bond issues.

This way, cyclical disruption by variations in the overall level of bank credit will be minimised. Money would be returned to its original purpose, for which it is best suited by being sound, which is to act as the temporary storage of production, and no more.

The sound money alternative

The alternative to inflation is to return to the conditions of sound money. It has to be sound and beyond the reach of governments as a means of inflationary financing. Deflation at the general price level is then a reflection of progress and improved living standards for all, through evolving product innovation and competition. The amount of money required in an economy must be set by markets, and it must be covered by further purchases or disposals of gold.

It should be noted here that preferences for and against holding money will always vary, even for sound money, but with sound money those variations are minimised. Variations in the general level of monetary preference can affect prices of goods and services most, so it is important the effect is lessened as much as possible. By sound money, we mean either physical gold itself, or substitutes convertible into gold on demand. And with gold or money substitutes, price arbitrage between states or regions also using sound money provides additional price stability.

These, broadly, were the conditions in Britain from 1817, when the new sovereigns were first minted, and after Britain returned to the gold standard proper in 1821. The gold standard was also adopted by other developed nations when they fell in line with Britain’s single standard, particular in the later decades of the nineteenth century onwards.

The enormous benefits and wide-spread wealth that sound money brought were traduced by socialists, such as Marx and Engels. A one-sided argument provoked envy at the wealth accumulating in the hands of successful businessmen and their families, derided as the bourgeoisie, by describing it as being at the expense of downtrodden workers. But the facts were very different, with living standards for manual labourers improving beyond all earlier recognition. Successful businesses earned their wealth through being subservient to consumers, by producing the products they wanted. If not, they went out of business. And while markets have delivered considerable benefits since, it is easy to establish that progress would have been even more beneficial to blue-collar and low-skilled workers, if free markets had been allowed to persist on their own without government intervention.[iv]

It is the stuff of obvious logic to understand that if wealth is transferred from ordinary people to the state, the people as a whole are poorer for it. It is a myth, perpetuated by the state, that wealth transferred in this way is held in trust for the population, when it fact it is destroyed.

If people are allowed instead to accumulate personal wealth, society as a whole, benefits. This is the key to understanding the benefits to a nation from sound money, because a successful economy is ultimately what gives the state its power. Before the First World War, Britain’s dominance over world trade was not due to its military campaigns; the navy and army merely protected free trade. It was the accumulation of wealth in the hands of entrepreneurs, backed by sound and reliable money accepted everywhere, that made Britain great. Its success was based on wealth creation, which accumulated in private hands with minimal government destruction.

The inflationists’ objection to sound money is that governments need to reduce their debt burden by eroding its value at the expense of their creditors. But as we have shown above, this argument is short-sighted, and ignores the mounting future obligations spawned by inflation. Instead of forcing increasing dependence on the state, sound money protects savings, allowing people to avoid state dependency. Instead of government obligations increasing over time, they decrease instead.

Following the Napoleonic Wars, the British Government was left with extremely high debts, which had to be paid down. Instead of yielding to the temptation to inflate them away, the solution chosen was to honour them with sound money. This was followed by the removal of economic distortions by the repeal in 1846 of the Corn Laws which had been mistakenly introduced in 1815, and the removal of other trade tariffs generally. Despite the gently falling prices of goods over time, the Government’s debt was reduced from over 250% of estimated GDP to only 30% before the First World War.

The return to sound money

The why and the how fiat currency must be replaced with gold as money, and fully-convertible money substitutes, has already been described. This was never fully achieved by the British government, because of a simple mistake in the implementation of the Bank Charter Act of 1844. While the Bank of England had by law to cover increases in its note issue with gold, control over the expansion of bank credit was neglected, because the consequences of making no distinction between cash and bank deposits were not properly understood. It was that mistake that permitted a credit cycle of alternate boom and bust to develop, leading to a series of banking crises in the second half of the century, and that cycle is still with us today.

A practical approach to the problem is to first recognise that central banks have succeeded in suppressing the gold price, measured against their fiat currencies. Replacing fiat currencies with gold and gold substitutes will require either a far higher gold price measured in fiat, or a massive contraction of fiat currency in issue, or alternatively some combination of the two. Furthermore, most bond markets are wildly overvalued, being priced on the back of central bank intervention. They do not reflect the risk that all fiat currencies’ purchasing powers are set for a decline. The realisation of a sharp fall in bond prices would be catastrophic for the banks that hold debt either as an investment or as collateral against loans. It is therefore likely a return to sound money will only occur for most jurisdictions after a global credit crisis, when the purchasing power of the currency is already sliding, we are in the midst of a global systemic crisis, and a return to sound money would be more acceptable, even demanded, by the public.[v]

There is the highest degree of anticipatory certainty that a catastrophic loss of purchasing power is where fiat currencies are headed, only the time-scale being open to question. Keep Venezuela in mind. Therefore, at some point gold should begin to discount this future event, and could rise to many times its current value, expressed in declining fiat currencies. This will, in theory, make it easier for central banks possessing physical gold to consider using it as a monetary stabiliser. But given the difficulties involved and decades of neo-Keynesian fallacies, it probably will be seen as a last resort.

There are two significant nations amongst a number of Asian states which could introduce sound money before or during the next credit cycle crisis, if they choose to, assuming they possess adequate undeclared physical gold. In the case of Russia, her banking system has already been pre-conditioned for severe monetary turbulence, thanks to Western sanctions and a collapse in the price of oil. Furthermore, her economy is oriented towards energy and commodity exports, whose values can be expected to decline less rapidly than Western currencies when the decline of Western currencies accelerates.

Russia is aggressively buying gold, joining China in her attempt to dominate physical gold markets. It is clear Russia sees gold rather than dollars as being important to her monetary and economic future. China has also demonstrated her understanding of gold. Having secretly accumulated it since 1983, China then encouraged her citizens to acquire it for themselves since 2002, and in the last few years embarked on a policy of gaining access, influence and control over foreign physical gold markets, such as London. Most recently, through a state-owned enterprise she plans to remonetise gold for day-to-day payments, in partnership with Goldmoney.[vi]

It is unclear at this stage to what extent these two dominant Asian states view gold as a monetary objective, as opposed to a strategic weapon to use against a belligerent America. There may be a divergence of views, with Russia more willing to destabilise the West by introducing a gold-backed rouble, than China by introducing a gold-backed yuan. However, it is unlikely that Russia and China will act independently, preferring to act together, taking a second tier of Asian nations with them, such as Iran, Turkey and other members of the Shanghai Cooperation Organisation.

China is almost certainly moving towards incorporating gold into her domestic monetary system, as outlined above. Her domestic monetary system is ring-fenced with capital controls from internationally circulating yuan, for which her policy has focused on improving its marketability as an international trade settlement currency. At some stage, these objectives are likely to come together, because the yuan is undermining the role of the US dollar, leading to its continuing weakness and therefore, a rising gold price. The timing of international developments is no longer closely controlled by China, because timing is shifting to the markets.

China must know that moves towards incorporating gold into the international yuan, or even threatening to do so, will drive US, EU and Japanese currencies relatively lower. Bond yields in these currencies will rise in response to price inflation, and that will almost certainly contribute to further currency destabilisation. China’s exporters will suffer, an undesirable consequence perhaps, but manageable. However, for the meantime we can only conclude China, Russia, and all the other allied Asian states await developments before going ahead with any form of gold convertibility.

For the West, it is another matter. Monetary economics remains dominated by neo-Keynesian thinking, which pursues economic planning and state control until free markets cease to exist. Official responses to the next debt-driven credit crisis will move away from sound money, rather than embrace it. Central banks are certain to throw more base-money at the banks and large corporations, to stop them going bust. Interest rates will be reduced to accommodate escalating government borrowing, and there will be more quantitative easing. Central bankers have no other response to adverse credit conditions.

Last time, a decade ago, there was a rush for liquidity. This time, thanks to ten years of “extraordinary measures”, the liquidity is there in spades. Only if you are a Nobel prize-winning economist perhaps, will you then ignore the inevitable collapse of the currency’s purchasing power and the hardship faced by ordinary people. You will declare the outlook for economic growth is good, like Professor Stiglitz regarding Venezuela ten years ago. It is at this point that China and Russia might decide to pull the trigger on gold convertibility.

Elsewhere, there is no appetite, no intellectual capacity, for a return to sound money. The West, particularly America, may feel it is the victim of a financial war against it, making them more belligerent. Putting that to one side, Western nations will have wound back the clock to the early 1920s, when Germany, Austria, Russia, Poland, Bulgaria, and Hungary all suffered currency collapses, their currencies being unbacked by gold. It is out of the ashes of a far larger global currency collapse in the coming years that a return to gold as the only money, and the return of circulating currency being fully convertible money-substitutes, is the eventual outcome.

[i] Measured by the fiat money quantity.

[ii] See

[iii] See

[iv] The fall of the Berlin wall exposed for all to see just how unsuccessful socialism had been to the east of it, in stark comparison to the conditions to the west, where freer markets had prevailed.

[v]It was public acceptance of the need for sound money that allowed the Austrian government in 1922 to stop the hyperinflation, even though Germany’s was accelerating and continued for another year.

[vi] The author must declare his interest, being a shareholder in Goldmoney. The announcement of this joint venture can be found here:

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