Land, Money and Inflation

There are many different theories of the basic cause of inflation, just as there are for depressions. But since today’s business cycle seems to involve a constant tension between periods of inflation and periods of unemployment/recession, the two phenomena clearly are related.

George said almost nothing in Progress and Poverty about inflation. Industrial depression was a much more serious problem. In George’s day, the supply of money was tied rather closely to that of precious metals, and it was nearly impossible for it to precipitously increase in supply. Inflation is defined as an increase in the supply of money, relative to the things it can buy — and therefore, a decrease in its buying power. Deflation is the opposite process, and it was much more prevalent in the 19th century. Only three of the years from 1866 to 1900 saw a positive rate of inflation. (1)

After the Great Depression of the 1930s, however, governments began using macroeconomic “pump-priming” to hold off economic downturns, or blunt their severity. This took the form of deficit spending by government, decreased interest rates, or both. But, of course, this amounted to injecting more money into the economy, which brought the risk of inflation. In the modern world, inflation is generally seen as the flipside danger to recession. The conventional macroeconomic wisdom is that the economy cannot be stimulated too much without risking excessive inflation — and the economy cannot be slowed down too quickly (via higher interest rates, tax increases, etc.) lest it bring on a recession.

Why talk of the risk of inflation? Cannot the government avoid inflation by simply choosing not to print more money? Not exactly. That is because all modern economies use a fractional-reserve banking system, in which the great majority of money is loaned into existence by banks (and paid back out of existence when loans are retired.) The bills and coins issued by the government are really only counters — useful in day-to-day transactions, but only a small fraction of the total amount of money.

Banks tend to loan out more money than they have on deposit. They do this whenever they are not explicitly prohibited from doing it. For centuries, bankers have understood that it is unlikely for all their depositors to demand their money back in cash, at once. They realized that it was worth the risk to loan out much of that deposited money, and to charge interest for the service of making that money available immediately.

From there, it is only a short stretch for banks to start lending out more money than they have on deposit. It’s risky — but, recognizing this, banks seek to establish reputations for trustworthiness and prudent management.

In a fractional reserve banking system, a bank is required to keep on reserve some percentage of the total amount of money that has been deposited there (today the requirement tends to hover around 10%). The rest can be loaned out. Thus, banks “create” the money that they loan out; it did not exist until the bank credits it to the borrower’s account. This money is, then, destroyed when it is paid back (or when the borrower defaults on the loan). During a given period of time, then, the rate of inflation amounts to the total of all money loaned out minus the total of all loans repaid (or defaulted).

The process can be influenced (by the government and/or the central bank) in two basic ways: either by adjusting interest rates (2) or by raising or lowering the portion of their deposits that banks must hold in reserve. These tools can influence the supply of money, but they cannot determine it — because banks are free to decide how much money they will lend, within the limits of the basic reserve requirement.

Land isn’t the Only Thing Bought with Borrowed Money

What does this have to do with the boom/bust cycle, and land speculation? Remember that in a modern economy, the vast majority of real estate is acquired with borrowed money. However, credit is not only important for acquiring land and buildings. Credit is also vital to daily business operations. Businesses routinely borrow money, for example, to purchase inventories. If the profit on the items sold is greater than the interest charged on the loan, then the business is better off borrowing. Such short-term business loans are considered to be “self-liquidating.” Their risk is quite low, and they facilitate the flow of commerce. (3)

Recall, too, that because of the basic nature of land as a factor of production, land value takes an ever-greater portion of aggregate wealth as the economy grows. This means that an ever-greater portion of aggregate borrowing must go to the acquisition of land. And, since the higher speculative value of land pushes people to build more expensive buildings, an increasing portion of loans also goes to buildings. Banks do not have unlimited funds to loan. Money committed to long-term loans for land and buildings is not available for short-term business loans.

Nevertheless, short-term business loans are essential to the smooth running of the economy. If less loanable funds are available, the cost of doing business goes up, and the economy slows. But, the supply of these short-term loans is inexorably restricted, as more and more loanable funds go toward buying land and buildings. Recession looms. The irresistible incentive for the Federal Reserve is to allow the money supply to increase, by keeping interest rates and reserve requirements low. This can offset the reduced supply of funds businesses need for day-to-day operations. But not indefinitely, and not without limit: since the central bank cannot control banks’ money-lending decisions, it cannot be sure that inflation won’t run out of control.

The fact that inflation and unemployment are seen as inextricably linked — that we seem unable to reduce one without risking the other — shows that they are symptoms of the same underlying problem.

moneyMany people note the intimate role of money and banking in economic cycles and assume that the financial system is at the root of the problem. Undoubtedly, the financial system has a long history of “ratcheting up” the volatility of the speculative land market. This was painfully clear in the Great Depression, and again in the 2000s, after many depression-era banking regulations had been eliminated. However, although the Glass-Steagall act and other regulations served to soften boom/bust cycles, it did not eliminate them. And, land price bubbles have recurred throughout history, under many different banking and monetary systems. Unfortunately, the primary role of land values in economic cycles has been obscured by the mainstream economics establishment, which has persistently denied land’s role as a distinct factor of production.

NOTES

1. The heavy deflation in the years directly following the Civil War was a result of the large infusion of paper money, “Greenbacks”, during the war. Here is a list of annual inflation rates during the 19th century. (Go back)
2. The Central Bank does this by raising or lowering the prime rate (the interest on short-term loans from the Federal Reserve to banks). This effectively increases the supply of money available for loan, and hence, increases the supply of money. In recent years, however, interest rates were lowered to nearly zero, and the Federal Reserve continued to stimulate the money supply via “quantitative easing” — in which the Fed directly bought financial assets from commercial banks and other private institutions. (Go back)
3. See Mason Gaffney, “Money, Credit and Crisis” in Georgist Journal #106, Autumn, 2006 (Go back)


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