The hyper guide to inflation

Inflation. Like the poor, always with us. Just one of those things? Well, no.

Chances are you haven't given it much thought. Prices go up a bit (apparently about 2.5% a year if the Bank of England are to be believed), you get paid a bit more, blahdy blah. Dull? No, absolutely not. Read on to the end to see that a crime is being committed.

So what causes it? Greedy merchants? Unproductive industries? BoE getting interest rates wrong?

Nope. It's much, much simpler. The government is increasing the money supply, in effect by printing more money. Can such a simple thing can be true? And if so, why is it allowed to happen?

Can it be true?

In econo-speak, the marginal utility of an additional "something" declines as the supply increases. One glass of water is great, but the 15th is not. Amazingly the same is true for money - you actually can have too much of it. Try this thought experiment. Those friendly martians call again and leave a mountain of fivers on each street corner. Try buying something, anything, the next day. I think you'll find that a can of baked beans will have greater buying power than a shedload of money.

The current best example is Zimbabwe which is in the throes of hyperinflation (about 150,000%), not seen since the days of the Weimar Republic.

Zimbabwe has had to introduce a new bank note: Z$10 million. Bear in mind that back in August 2006 they slashed off three zeros anyway, so this is really a 10 billion dollar note. It is the equivalent of about $4 at the black market exchange rate. (In 1980 a Zim dollar was worth more than a US dollar).

(Text added 5 June 2008 - after a comment by absolute vanilla I looked up the latest conversion rate. I was WAY out of date. Today Z$10 million will get you, not US $4, but 2 cents).

The government seeks to blame everyone but themselves. In February 2007 they declared inflation "illegal". Anyone raising prices or wages would be arrested and punished. But the actual cause is the simple one, the government is printing money on a vast scale.

On 1 March 2008, it was reported by The Sunday Times that the Munich company Giesecke & Devrient (G&D) was receiving more than €500,000 (£382,000) a week for delivering bank notes at the astonishing rate of Z$170 trillion a week. Which looks like this: Z$170,000,000,000,000. Or this much a day: Z$24,000,000,000,000. Which is why prices keep doubling every few days.

Why does Mugabe do this?

Let's start with Zimbabwe, but the logic holds for all governments where there is inflation. The Zimbabwean government prints money to pay its bills. The process, though mad, works, and it works on the marginal utility basis.

Say Mugabe wants a new Merc, or needs to pay the army before they go apeshit. He prints a couple of trillion. Because those notes are not "in" the economy yet, they have the same worth as other dollars up to and at the point at which they are spent. However, after they are spent they cause the money supply to increase, and the value falls proportionately. So he gets a free lunch, but no one else does. And then he goes and does it again.

It's weird. He's like a kid who has a fiver and a colour photocopier, who actually thinks that he can generate value that way. The only difference is we can make the kid stop.

Why do other governments do this?

Governments have no money of their own. They get it three ways. They take ours by tax, they borrow someone else's or they print it. Excessive taxation turns voters against them, debt needs to be serviced, but hey, printing money is like fat-free cake.

Remember marginal utility? When the government has a pet project, or stupidly commits to bailing out a failing bank no matter what, it can finance it by printing money. It has full value up to the moment the government spends it; then, after it is spent (i.e. enters the economy), it dilutes all money pro rata. Note that the government gets the full value benefit, we get the devalued currency.

Now most governments don't go crazy like Mugabe. They do it at 2.5% like in the UK. It's pretty clever really. It transfers 2.5% of everyone's wealth to the government, every year, without anyone noticing. Much like a "victimless" crime.

Postscript 1: Wars are followed by periods of high inflation. This is one of the ways governments pay for them, i.e. with devalued currencies. The cost of the war in Iraq is now about half a trillion dollars, or getting on for 10% of the entire cost of WWII. I don't know what the UK's share of this is, but its citizens had better brace themselves for some upcoming inflation (see Postscript 2).

Postscript 2: The markets know about devalued currencies long before the rest of us, sometimes before the government I suspect. Have a look at this chart for the Euro/Pound pair. It shows that for the last several years it used to cost about 67p to buy a Euro.

From the middle of last year that changed and it now costs up to 80p to buy the same Euro. Which means the Pound has fallen some 20% against the Euro. (See Postscript 1).

Click image to enlarge it.