The Trouble with Central Banks

With the “World Economic Crisis” here and on its way, there seems to be some worry about hyperinflation. This certainly could happen, but the state would have to go drastically insolvent. There is such a terror over defecit spending in Canada, I doubt we will come to be over extended in this way.

The danger that seems to me much more real is regular inflation. People seem to think “inflation is prices going up”. Well, that’s true, price inflation is prices going up. It’s caused by the deflation of the economy with respect to the money supply. If the money supply was constant (e.g. Gold standard, no fractional reserves, and state refuses to buy any new gold), then inflation would signal a reduction in available services. However, if the state does purchase gold in exchange for coinage or gold certificates, an increase in these certificates with respect to an unchanging amount of goods and services will also produce price increases (there is “more money” but it can only buy the same amount in total).

Now, since we don’t have a commodity standard (and there is no reason one has to pick gold, money could be issued as rice certificates, or sawdust cirtificates, but storage and transport makes this unreasonable), and the money supply is controlled by a central bank, inflation is the product of the central bank increasing the money supply faster than the economy grows. So, if growth is 3%, and inflation is 2%, the increase in the money supply was 5%.

The central bank increases the money supply in a fractional reserve system by lowering the overnight lending rate. This encourages banks to seek lower returns on loans, and gave us the sub-prime mortgage phenomenon in the U.S.

What this seems to mean is that the amount of money a lender can make goes down – both in real and nominal terms. In nominal terms because the interest rate has lowered, and in real terms because – and this is key – increasing the money supply with respect to size of the economy causes inflation, so the very lowering of the interest rates causes the currency to be devalued, which means the amount paid back on the loan is always less (in principle and in interest) than was taken out. In other words, the value of loans shrink (the principle) as the currency is inflated, at the same time, for the same reasons as the interet rate (which produces the interest) is lowered.

This means, the standard response to the collapse of economic bubbles – to lower the interest rate – also causes inflation, and this discourages savings.

Why would anyone want to save, when you can take out loans and invest them elsewhere to make a profit?

To go back in time, why would anyone have wanted to save in the 70s and 80s, when inflation was in the double digits? That means the principle of loans was shrinking by 10% a year!


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