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Bernholz, Monetary Regimes and Inflation, 7 [ClearOnMoney]
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Commentary

Bernholz, Monetary Regimes and Inflation, 7

10 Sep 2010 by Jim Fickett.

In Chapter 7 Bernholz describes the main political forces at work when moderate inflations are ended. Most of the points are fairly obvious, though it is interesting to see how they work out in the many historical examples discussed. One less obvious point is that, since inflation tends to result in undervaluation of the currency, exporters are often less than enthusiastic about currency reform.

Chapter 7 is titled, “Ending mild or moderate inflations”. This chapter discusses the political forces at work when a moderate inflation is ended and a more stable currency is (re-)introduced. The main forces at work in pushing politicians to end inflation are

  • National pride
  • A feeling, after a war or other traumatic event that ruined the budget, that things should be restored to their former state
  • Trade interests, if the currency is used internationally and must be stable for those trade interests to be defended
  • The pain of business inefficiencies and erosion of personal savings, caused by the inflation, once the initial stimulus effect wears off

The timing of events in typical inflations plays two important political roles. First, an important reason for the frequent occurrence of inflation is that in the early stages, the increase in the money supply provides a stimulus effect, while the bad effects of price dislocation and declining savings come later. And it is often when the stimulus has worn off and the pain is setting in that the political will arises to challenge the money printing.

Second, typically the exchange rate reacts more quickly and strongly than domestic prices, so that inflation results in undervaluation of the currency. This benefits exporters, and domestic industries that compete with imports. They tend to resist ending the inflation in any way that also extinguishes the undervaluation. Bernholz shows that it is common to find political compromises in which the inflation is ended, but at a new parity, to some external standard, that provides some undervaluation.

So set against the main forces pushing to end inflation, listed above, the main forces pushing to continue the inflation are

  • Politicians' desire to spend without cost
  • Certain industries' desire for an undervalued currency

Bernholz goes through a number of historical examples, showing how these forces have played out in practice. It is a pleasurable and illuminating read.

Previous chapter reviews

Bernholz, Monetary Regimes and Inflation, 1: This post is a review of the first chapter of Monetary Regimes and Inflation, by Peter Bernholz. Already in this first, introductory chapter it is clear that all material will be treated in an insightful manner and illustrated from the author's broad knowledge of history.

Bernholz, Monetary Regimes and Inflation, 2: The main message of Chapter 2 is that governments have a natural tendency to deficit spending and inflation, and inflation is only absent if somehow the hands of the leaders are bound. This happens most dependably with a gold standard, but an independent central bank, or a fixed exchange rate with another stable currency, can also help.

Bernholz, Monetary Regimes and Inflation, 3: Inflation can occur even under a precious metal standard, either by influx of more of the metal from abroad or, more usually, by debasement of the currency. Debasement has been accompanied, for thousands of years, by price and exchange controls. These never prevent inflation and hoarding, but do cause market disruption and considerable suffering. A precious metal standard can be introduced, and maintained for long periods, if it is in the economic interest of a government. The merchant city-states of Venice and Florence provide an example.

Bernholz, Monetary Regimes and Inflation, 4: There are several features typical of most moderate inflations. For example (1) the money supply typically rises earlier and faster then the price of better money, which rises earlier and faster than the prices of goods and services. And (2) because the money supply rises before unit values decrease, an economic stimulus is often an early effect.

Bernholz, Monetary Regimes and Inflation, 5: Hyperinflations are caused by excessive budget deficits – there is no other conclusion possible in light of the historical record. A fundamental feature of hyperinflations is that other, good currencies are overvalued, relative to prices, and the real value of all money in circulation goes almost to zero, compared to its value before the inflation. This means much of commerce is based on barter and, though pushed underground by extreme penalties, the use of foreign currencies or precious metals. There are ways, if one is prepared, to survive even hyperinflations.

Bernholz, Monetary Regimes and Inflation, 6: Chapter 6 introduces a simple mathematical model of inflation. The model suggests that in any context where inflation may arise it is important to watch the relative demand for the currency which is possibly inflating and any alternate, more solid currencies.