Advisory and Structuring

Inflation – A Brief History of a Cunning Plan

Did you know that inflation is a very cunning form of indirect taxation? Well, what else would you call a government ploy that reduces the value of its money? This leads to a reduction in the purchasing power of your unit of currency. Effectively, it means that both your savings and your salary can buy fewer goods and services than before. Essentially, after your currency has been inflated, you will have to work longer and harder to acquire goods and services than you would have before. Of course, economists, and finance ministers argue that there are positive effects for inflation, such as the reduction of private and (even more importantly) government debt. But this is simply a nice way of saying that inflation balances out the effects of fiscal irresponsibility. Hence, through inflation, governments are making you work harder to pay for their fiscal irresponsibility, which is currently reaching titanic levels.

Now inflation is strongly associated with contemporary governments heavily laden by huge public debt and with fiat money as their legal tender. You can see why. What easier way is there to keep public debt under control than by printing more units of a paper currency backed by nothing except a government’s promises? People ignore the effect of small rates of inflation, but they are shocking nonetheless. For example, at a rate of inflation of 1%, the value of savings of $100,000 falls to around $90,000 in ten years. Now imagine how far worse it can be in countries in which, through government irresponsibility and political turmoil, inflation shoots off the charts.

Inflation is strongly associated with fiat money. This is not surprising. With money that is backed by nothing, all a government has to do is to print more banknotes to devalue its debt through inflation. But, in fact, even commodity money is vulnerable to inflation. Governments have always been extremely devious about such matters, but, to understand how, we need to take a quick peek at the past.

Money & the Emergence of Coinage

Money is a payment system that has four functions. It is a medium of exchange, a store of value, a standard of deferred payment, and a measure of value. It seems that the first form of money was commodity money, in which a weight of some commodity of value (food, useful metals, etc.) was used as money in much the same way as we use banknotes and coins. But in the 7th century BCE, coins were struck from commodities such as gold, silver, bronze and copper. The value of these coins was derived from the value of the weight of that metal out of which they were made. The first coins appear to have been struck in what is now western Turkey and they started to circulate in that region. Although these coins were stamped with the marks of their issuers, they were easily accepted very widely because of the intrinsic value of the metal out of which they were made. Money does not have to come in the form of a coin, of course, but commodity money based on coinage has many advantages, notably portability and wide currency. Think of how much easier it is to carry out business in a distant country through the use of gold coins than by exchanging the merchandise for some other commodity such as cartloads of wheat. But coinage based on commodities such as precious metal have other advantages, perhaps the most notable is that it is immune to the inflation that contemporary fiat money is so susceptible to. Or so you would think.

Inflation of coinage

Have you ever noticed how ancient coins seem to be gnawed around the edges? Many governments simply could not resist shaving a tiny amount of the base metal of a coin every time that it ran into their treasury. These tiny slivers of metal would mount up dramatically across large numbers of coins, leading to massive inflation. However, I am running ahead of myself.

At first, small kingdoms and city-states, especially if efficiently run, had little reason to plot inflation. However, as these small states grew into giant empires lasting many centuries, they were eventually beset by problems similar to that faced by our own large states. Perhaps the best example is the Roman Empire. In the 2nd century CE, the Roman Empire was beset by a series of challenges that included a cooling climate, falling harvests, famine, illness, political turbulence, greater immigration and military challenges. The emperors struggled to control all these problems that they tried to do so by increasing public expenditure. Unfortunately, these very challenges brutally devastated the Roman economy, leaving the emperors with little money at their disposal. So their great idea was to cheat by meddling with their coinage in a way that is called “debasement”. One of the methods of debasing was by shaving (or clipping), as I have already outlined. But another one was to mix the content of a metal coin with an inferior metal. A silver coin worth x amount would be mixed with a percentage of steel or copper. This would put more silver into the Empire’s treasury and then it would be circulated once more in the form of new coins. But the effects were devastating, pretty much the same as that of hyperinflation today. Confidence in empire’s coinage collapsed because the intrinsic value of the coins fell significantly below its nominal value. Prices exploded, devastating the Roman economy even more, and weakening the state further, fuelling more unrest. In fact, there is a correlation between debasement and the assassination of emperors. A few centuries later, the Roman Empire fell.

A modern solution to an ancient problem

Today, some people are advocating a return to commodity money to combat the abuses of the current system. But history shows that this is no solution. A determined government will always find ways to abuse its money. It seems that so long as money remains exclusively in the hands of governments, there will be no solution.

But perhaps money will not remain exclusively in the hands of government anymore. For there is a revolution underfoot. In 2009, an unknown individual released a decentralised electronic payment system called Bitcoin. Bitcoin runs on four technologies that make it peer-to-peer, give it all the properties of money, and is fully decentralised and outside the powers of government control. It is also essentially an expression of data, making it intangible, and therefore impervious to tangible manipulation. Moreover, it is backed by a very tangible asset – the expenditure of electricity needed to guarantee the integrity of the system through hugely complex mathematical calculations. So Bitcoin combines the best of our systems of money – intangibility, and therefore ultimate portability, and basis on a limited resource. Moreover, Bitcoin has been designed to be scarce by nature, with a total eventual limit (to be achieved by 2140 or so) of 21,000,000 coins. It is therefore ultimately deflationary, and there is nothing that any central authority can do to change this, or to control transactions in this type of money between peers willing to transact in it.

Bitcoin is truly a watershed in history. For Bitcoin is a system of money that bypasses central authorities and is impervious to their control and abuse. Of course, this will not mean the end of the state, but, by providing a credible and highly practical alternative to government money, Bitcoin should surely provide incentives for governments to make at least some effort to curb their abuse of monetary supply and policy.

N.B. – This essay goes over issues that are of immense complexity. For reasons of space, the author has had to grossly oversimplify all the issues he outlines. Therefore this essay should be considered nothing more than a very basic overview of the subject it tackles.

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