Inflation: A Tax in Disguise

Sep 2012

Milton Friedman famously argued that “inflation is always and everywhere a monetary phenomenon.”  So, should we therefore put most of the blame for inflation on the keepers of monetary policy (central banks like the Fed, the European Central Bank, the Bank of England, etc.), rather than on over-reaching politicians?  The answer is yes—and no. (This type of economist-speak used to exasperate President Harry Truman, but please read on.)  Yes, if central banks absolutely refused to expand the money supply faster than inflation-adjusted (“real”) economic growth, there would be virtually no inflation.  So inflation is a monetary phenomenon, just as Friedman said.  However, we should ask why central banks create inflationary money supply growth.  After all, with a few notable historical exceptions, they’re not stupid.  The simplest answer is that if they didn’t significantly expand money supplies, tax and spending programs (fiscal policy) would ultimately drive government finances to an untenable position.  Governments might not be able to pay their bills, resulting in disruptive defaults.  Faced with the choice of default-induced economic disruption or more inflation, central banks typically choose the lesser of evils—inflation.  Put differently, when politicians don’t raise taxes or reduce spending sufficiently to provide for noninflationary economic growth, central banks allow the disguised “tax” of inflation to rob everyone of enough purchasing power to accomplish that which politicians are unwilling to accomplish more openly and directly.  So one can make the case that it’s the taxing and spending policies of various governments that ultimately drive inflation.  This explanation strikes us as being more realistic in most cases.