Inflation: How it occurs and what are its consequences

Inflation: How it occurs and what are its consequences

Guided by Austrian school economics, I have attempted to outline firstly the different mechanisms through which inflation may occur.  Secondly, I have noted some of the second-order consequences that might be expected as a result of these primary mechanisms. Finally, I have made some observations about how this framework relates to investment today.  I hope it may be of some interest.

Inflation, as defined by the generalised move in prices can happen in one of four ways 

1)      An increase in central bank base money is inflationary.  This happens when the central bank buys assets with newly created money.  All things being equal (which they never are), if the commercial banks maintain leverage at constant levels, this increase in base money will be amplified such that the total money in the system will move up in proportion to the increase in quantity of base money.  This is inflationary since money supply increases and yet total goods and services does not.

2)      An increase in commercial bank leverage is inflationary.  Commercial banks have the ability to increase their leverage by making new loans.  These new bank assets result in new deposits being created.  Thus, this is an inflation since money supply increases while total goods and services do not.

3)      A decrease in the willingness to hold cash is inflationary. If people feel less cautious and prefer to hold less cash thus, spending it on goods, this will result on the price of goods more generally increasing.  Note that the absolute amount of cash does not change, it is only the perception of relative value between cash and goods.   Hyperinflation is actually an extreme version of this phenomenon, where people decide to put zero value on their cash holdings.

4)      A decrease in the quantity of goods and services is inflationary.  It is actually easier to think about the reverse process, which is one in which capital is invested into new productive machinery which produces goods at lower prices and of higher quality.  Capitalists are rewarded by consumers with profit if these projects succeed.  This results in the quantity of goods increasing and their average price decreasing. It is a deflationary process.  The level of deflation will depend upon three things.

–          Firstly, the quantity of real capital that is put to work. If more is invested, this will result in more machinery being produced, which – all things being equal – should result in more deflation.

–          Secondly, the efficiency with which capital is deployed (if most capital goes into keeping unproductive machinery running, this will be less-deflationary).

–          Thirdly, the available number of investment projects. Sometimes, there is a new method of production which materially changes the cost structure of the industry.  These technological leaps will tend to result in more deflation.  They should also result in a greater proportion of capital being invested rather than consumed, which will amplify this effect.

Secondary issues of these inflationary mechanisms


While these four mechanism of inflation/deflation broadly describe how generalised price moves can occur, this tells us nothing about relative price moves.  For investment purposes, these are usually more important than the generalised moves since it is these moves that benefit one party over another.  If all that inflation did were to mark the prices of goods up and down together, with all parties benefitting equally, then no one would much care.


Important relative price moves do occur as a secondary consequence of these primary inflationary mechanisms.  These were first written about by Richard Cantillon in the famous 1730 L’Essai.  The principle is that in an inflation caused by the creation of new money (mechanisms 1 and 2 above) that the first receivers of the new money are its beneficiaries, while all others are losers.  This is self-evident since no new goods and services are brought into being by any additional money.  Thus, while the same set of goods and services are available, the money supply is increased, but this new money is only at first available to a particular party – the first receiver.


Cantillon himself, through understanding these principles, made a fortune in the South Sea Bubble but was subsequently murdered by one of his debtors who claimed bitterly he was a fraudster.

Over the years, huge fortunes have been raised and dashed through these secondary effects.


We can put this into today’s context thus:


Prior to the financial crisis, property owners were the biggest winners through Cantillon effects.  It happened like this: commercial banks creating new loans was the dominant mechanism of money growth.  Thus, the first receivers of this new money were those who were willing to take out these loans.  The principal asset bought with new debt was residential property, which drove up its value.

Following the financial crisis, commercial banks have reduced their loan books (thus the impact of mechanism 2 changed from being an inflationary impetus to a deflationary one.  The reaction of the central banks has been to create new base money (mechanism 1) and use this to buy a sufficient quantity of government bonds such that generalised price inflation was again observed.  Thus, the first receiver of this new money changed from being the homeowner to the government bond owner.  Thus, asset class leadership moved from property to bonds.


I would note with horror here the sheer number of people who have become rich in the UK simply through home ownership (a Cantillon consequence of inflation mechanism 2).  This dwarfs those who have become wealth through successfully investing properly through the capitalistic process (as described in mechanism 4).  This is illustrative of how important this issue is.  Incredibly, central banks do not even consider Cantillon effects in their models, and yet it is they that underwrote the expansion of commercial banks’ balance sheets.


Some consequences of these issues


1)      Labelling an environment as ‘inflationary’ or ‘deflationary’ is very misleading.  Firstly, there are various different methods through which inflation can occur.  Each has rather different consequences, and the result of what is seen is as a consequence of all of these effects superimposed over each other and happening simultaneously.  In addition, it is the relative price moves that ensue from these mechanisms that is rather more important.  The number of property millionaires in the UK is testament to this.

2)      To the extent that capital has been misdirected throughout the economy, then this would tend to put money into poor returning projects, and this is inflationary.  If the capital had been better-directed, it would tend to be put into areas that would increase productivity and thus rapidly accelerate the reduction in prices (through mechanism 4).  The boom in residential property prices and subsequent increase in bond price has been the result of capital being misdirected away from productive investments.

3)      Technological progress has meant that the number of available high return projects has increased enormously.  Given the number of new ways of ordering production, there are many more ways through which goods can theoretically be produced at lower prices.  These are high return projects that deliver tremendous benefit in the form of new goods at lower prices to society.  Despite central banks’ misdirecting the capital allocation process, many of these new projects have still received investment.  The effect has firstly been very profitable for the companies involved and secondly resulted in huge declines in real prices.  This effect would have been even more marked if central banks had allowed more of the available real capital to be directed into these areas.

4)      The prices of financial assets is affected strongly by the flow of money (among which are the important Cantillon effects), rather than any broad perception of inflation or deflation.  As discussed, inflation and deflation can occur as a result of a range of different mechanisms, each of which have different effects.  Therefore, the idea that the aggregate effect of all of these broad price changes has a consistent effect upon the relative prices of different assets is peculiar when one considers that the dominating factor causing inflation or deflation may vary a lot.  E.g. If banks default on their debts (mechanism 2), this would cause a reduction in bank liabilities, and deflation.  However, the yield on bonds would –all things being equal – rise due to greater credit risk.  However, if deflation is caused by mechanism 3, individuals putting a greater value on cash over real goods, there is no particular reason for bond yields to rise or fall.

5)      A large part of the reason for low yield of bonds has been that they have benefitted from Cantillon effects.  As explained above, since the financial crisis, the dominant mechanism of inflation has been central bank money creation.  With this new money, the asset of choice to be bought has been the government bond.  Thus, this is the asset class most vulnerable to a change in the mechanism.

6)      It is possible that, following the Trump election, that the mechanism of inflation/deflation has changed again.  The fact that Trump has indicated that new money will be directly fund government spending is indicative of the idea that outright deflation is unlikely, but that the beneficiary of central bank money creation might not exclusively be government bond holders as it has been hitherto.  It is to this that the market has reacted.

7)      Valuation should be the guide for investors.  The implication of the issues raised here are that Cantillon effects are very important.  Cantillon effects will tend to push the market value away from fair value for a period of time.  However, these effects do not last forever and asset leadership can change. What valuation can do is to give an indication of how far away from reality Cantillon effects have taken us.


Tags from the story
Written By
More from Tim Lucas
Building White Elephants in China
Loose US monetary policy has had its echoes all around the world. ...
Read More
0 replies on “Inflation: How it occurs and what are its consequences”