Wednesday, May 11, 2011

Money printing and inflation

The single biggest issue everyone has on their mind right now is probably the rising cost of living. Protest from 'youth' and others have called on the government to somehow reduce the rising costs. It seems that, no one has actually adequately explained to the public, what actually is going on, and why things are getting more expensive. So let me try.

First, money is a medium of exchange and a store of value. Being a sovereign nation, we (as in government) creates our currency Rufiyaa. The notes on itself has no intrinsic value[1]. The only value the Rufiyaa has is the fact that people accept it in exchange for other goods and services.

Secondly, money is printed by the government and injected in to the economy. People use the money to exchange goods. If not for the money (created by legal tender, or arising naturally), we would be trading in barter.

Suppose I sell a laptop for Rf7000. I have no intrinsic use of the Rf7000, except that I can use those to buy product/service that I need, or save for future use. If there is a higher demand for laptops, the prices tend to rise (just like other goods). Generally, given a quantity of Rufiyaa Q in the economy, the general price level P of goods remain the same (this price level P is reflective of cost of living as measured by various indices such as Consumer Price Index). However, the price level P might change in two ways.

One, if the production of goods keep on increasing, then the price level will generally reduce (given a fixed quantity of Rufiyaa Q). This is because there will be same amount of Rufiyaa chasing more goods, in effect, each Rufiyaa is able to purchase more goods. This is called an increase in the 'purchasing power' of Rufiyaa.

Second, if for some reason the quantity of money Q is increased at a faster rate than the production of goods, then the reverse will happen. Much more Rufiyaa will be chasing same or (slightly increased) goods. This additional demand placed on the goods will cause the prices of goods to rise, ie a rise in the general price level P. In effect, more Rufiyaa will be needed to buy the same good, thus reducing the purchasing power of Rufiyaa.

So how does, and more importantly, why does Q (the quantity of money) increase? There is only one answer: The government prints them![2].

But why? To answer that, we have to look at how governments get money to meet its expenses. Government, gets money from few sources: Taxes/fees, borrowing/loans (local or foreign), foreign aid, printing currency, or leasing/selling assets. To meet its expenses such as wages, infrastructure, loan repayment, etc, it has to get money from one of the above methods. Whatever program of expenses the government has (be it civil service or parliament salary, harbours, pensions etc), the government has to engage in one or more of the above means to finance its expenses, for which the public will ultimately have to pay.

If the expenses of the government can be met with revenues (via taxes/fees), then there is no need to resort to other methods. It is only when the government expense is more than its revenue (ie. when it has a deficit budget), that the government has to resort to borrowing or printing of money. Some argue that there is nothing inherently wrong[3] with borrowing (local or foreign) as long as it is for productive, revenue generating capital expenditure or to correct some short term imbalances.

Historically, raising taxes is politically less desirable. Loans depend on the credibility of the government to repay it back, especially foreign denominated ones. Selling assets is a short term solution, which leaves us with printing money. Printing money is very attractive to politicians, as there is no need pass legislations to print them, or there is no pressure due to raising taxes. Thus, large deficit budgets over many years can be financed only by increasing the quantity of money. As previously mentioned, increasing Q (faster than the rise in productivity) will result in a rising of the price level, ergo inflation.

As this new money gets injected into the economy, more Rufiyaa will be chasing the same goods/services, thus putting upward pressure on the prices. The rise in prices does not come immediately. It comes when the new money circulate throughout the economy. Where the government injects the money has an important effect on who actually benefits from such money.

Suppose that, due to rising costs, government decides to print Rf100,000 per each citizen and distribute it simultaneously to each and every citizen. The question is, will this solve the problem of rising costs (with an extra 100k, aren't we all better off)? The short answer is No. At first, people will start spending the newly gotten money. As more and more people place demand on goods/services that they would otherwise not have placed demands on, the prices rise. Ultimately, the general price level stabilises at a point where we are not better off. Our nominal income has increased, but our real income (adjusted for purchasing power) has declined, because we now have Rufiyaa that has much lower purchasing power! And we have reduced the real value of our savings.

Obviously, the government does not print the money and distribute equally as stated above. But it does print and inject the new money somewhere. The newly created money is injected via government expenses such as salary, benefits, capital expenditure etc. The people who gets this new money first are government contractors, consultants, civil servants and others salaried on the public purse. When they go and spend that money the prices have not risen yet, so they get great benefits. Ultimately, the new money circulates to others such as friends, kanmathee fihaara, coffee shops, etc. By the time the new money reaches down the chain to common worker, the prices have risen in the market, and they have to pay for higher price from the same fixed income! Thus, inflation is a very very regressive tax[5] on ordinary people (especially those on fixed income). The poor (whose incomes are already small, and have less savings) are hurt most as their wages and savings will have less purchasing power!

So what is the solution? Balancing state budget by reducing expenses, matching that with reasonable taxes, or in short, government living within it's means. Note that I didnt say live within 'our' means. 'We' the ordinary people are trying to live within our means. Our expenses match with our incomes (though it is becoming more and more difficult lately), or we borrow only in emergency or for investments. Ofcourse, we also have exception to this rule, but generally we are law abiding citizens that are just trying to live within our means. It is the government[4] that has always and consistently mismanaged it's finances, but we the people have to ultimately pay.

[1] - It used to be that world currencies were backed fully or partially with gold/silver or some other commodity. This is no longer the case, and is called 'fiat' currency. What 'backs' such currency is the productive output of goods and services that people accept by exchanging the currency.

[2] - Technically in today's world, the central bank does it on behalf of the government via various methods such as bonds/T-bills etc. Printing per se may not occur, it might be just an entry in an electronic account. In addition, there are many other tools available to the central bank to control money supply.

[3] - There is still the issue of sovereign loans, where the incumbent government borrows heavily for pet projects inline with the election year. The issue is that the debt has to be ultimately paid by the citizens (the politicians will be long gone), which is sometimes a very heavy burden. You and your children are subject to this debt, which you have not consented to in the first place!

[4] - Government here meaning the entire State apparatus including judiciary, executive, independent institutions, parliament etc.

[5] - It is generally agreed by most economists that a low level of inflation (1% to 3% per year) is healthy (and there are good reasons why). There are situations where injecting money may not cause inflation, such as when the economy is in a recession/depression, such as what they are currently doing in US with Quantitative Easing.

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