Taming the inflation monster

Looking back at a suggestion on stripping governments of their monopoly over the supply of money

June 06, 2017 12:05 am | Updated 12:39 am IST

Inflation affects everyone. As prices rise, an individual’s ability to afford goods diminishes unless his income increases proportionately. Yet, it has become so common to see prices rise over time that inflation is consider normal, and even harmless. In fact, most economists today agree that a moderate price inflation is a sign of a healthy economy with sufficient demand to keep everyone employed.

The most common cause of inflation is the increase in the total money supply in the economy. “Inflation is always and everywhere a monetary phenomenon,” economist Milton Friedman famously said to emphasise the influence of money supply on prices. But what explains the almost-unstoppable increase in the money supply in modern economies? After all, when the world used gold as its primary currency prior to the 20th century, both money supply and prices showed remarkable stability.

Reckless spending

To rein in the supply of money, economists at the Chicago School favoured the adoption of a rules-based monetary policy that mandated central banks to maintain a stable rate of inflation. Such a policy was supposed to tie the hands of spendthrift governments that hoped to fund their expenses by recklessly creating new money. However, history suggests that governments invariably exert political influence over the decisions of the central bank, and thus over the supply of money too. “Choice in Currency: A Way to Stop Inflation,” a 1976 essay by Austrian economist Friedrich A. Hayek, offered a more novel solution to the challenge of controlling the money supply. Hayek proposed that governments be stripped of their monopoly privilege to supply money. Instead, private companies should be allowed to offer their own money in the market, thus competing with money issued by governments.

This, Hayek argued, would discipline governments that create money in a reckless manner, as citizens can freely switch to alternative currencies that offered better value. In this context, it is worth noting that metals like gold already act as alternative currencies that citizens demand during times of high inflation.

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