If there is one thing we need to understand in the next few years, it is inflation. While Obama is obviously bent on raising taxes, and raising them far more than claimed, he is unlikely to raise them enough to cover his massive spending plans. And at the moment, with nary a tax increase in sight, he has already spent well over a trillion dollars, making it clear that for the foreseeable future he will be engaging in massive deficit spending. As the market is weak, being in the midst of a liquidity crisis, and as future tax increases will leave even less money available for private financing, any deficit spending means only one thing, massive expansion of the money supply. That is, inflation.

First, let me confess to a mistake. I have been following other pundits in saying "Obama is going to print $1 trillion dollars", knowing well enough that is a mistake. However, I have let it lead me into the mistaken assumption that Obama is increasing our $14 trillion money supply by about 7%. In truth, he is authorizing the Fed to buy $1 trillion dollars in bonds. When member banks submit those note, they will be credited against the member bank reserves, allowing them to issue $3-4 trillion in new loans or other instruments. So, Obama is actually increasing the money supply by 20-25%, not 7% as I intially thought. And he plans to increase it by the same amount or more each of the next three years.

And that is what we have to look forward to. While we have grown used to 3-5% increases in prices, thinking of that relatively massive inflation as "normal", becoming accustomed to the absurdly low 4-5% interest rates we have had for several years, that will be nothing compared to Obama's inflation. Granted, interest rates won't stay low for long with an anticipated 20% increase in the money supply per annum, but price increases will become a fact of life. In fact, with an easily anticipated growth, prices will likely race ahead of inflation, leading to price increases of 30% or more, with interest rates rapidly rising into the double digits. If Obama does not revise his plans and engages in the massive deficit financing he has announced, we will experience inflation to put the Carter years to shame.

And that is the topic I wish to address. Not inflation in general, I have covered that many times. What I want to discuss is inflation as a cause of uncertainty.

A long time ago, when speaking of the law, I discussed how legal certainty is more important that anything else, how a predictable tyrant is better than the most benevolent but capricious government. And the reason should be obvious. All planning is based upon each action having a predictable outcome. Even when results are uncertain one must have an idea of the likely outcomes and their relative probability. And that is what a predictable set of laws gives. By removing arbitrary human decisions from the outcomes, laws make the outcomes mechanistic, predictable, and make it possible to engage in long term planning, because one can predict what the result of any decision will be.

Inflation results in similar chaos. I have described before how inflation causes companies to over estimate their profits and end up paying out their capital in dividends, but that is just the beginning. Even though companies try to deal with inflation by changing accounting methods, recalculating depreciation, adding inflation premiums to interest rates and so on, in reality, any such measure is at best an approximation. As the effects of inflation are unevenly distributed and unpredictable, any indexing will of necessity get the numbers wrong. As a result, rational business planning becomes impossible.

The breakdown of planning has two outcomes.

At first, because of the increased risks of the business environment, it causes businesses to quietly add a "risk premium" to their prices, In essence, they try to pad out their profits to allow for the inevitable losses when their planning proves inadequate. However, this often puts prudent firms at a disadvantage, when less prudent firms underestimate the risk, charge too small a premium, and undercut prices. Of course this eventually causes those firms to fail, but in the meantime, it forces all firms to either underestimate their risk or else suffer decreased sales.

Eventually, however, the uncertainty gets too great and firms simply cannot apply a high enough premium to compensate for the uncertainty. If they cannot change their business model to allow for payment in tangible assets rather than money, thus bypassing the inflationary currency, then firms begin to shut their doors. And that is the end point of any hyper-inflation. Eventually the inflation becomes so bad firms either must trade in non-monetary exchanges, basically revert to barter, or else they will refuse to trade at all, as the currency has become effectively worthless.

And that is the real risk of inflation. Yes, the way it erodes values, destroys the principles of lending, rewards spendthrifts and punishes savers, and the way it unevenly effects the markets causing the creation of arbitrary winners and losers are all damaging. But they also are not enough on their own to undermine the whole free market system. But the uncertainty that inflation introduces is. Eventually, the inability to plan will destroy the market.

POSTSCRIPT

When I say the money has effectively become worthless, I mean that quite literally. As money's primary benefit is in being a durable store of value, once inflation causes money to lose almost all of its value in a day or less, it is no longer useful as a medium of exchange. When people are afraid to hold money for fear of losing any value it may have had, then money has become nothing but a scrap of paper.

POSTSCRIPT II

Some of my writing on inflation can be found in the following posts:

Two Perspectives
Inventing a Crisis
Inventing a Crisis II
Inventing a Crisis III
Monetary Issues Made Simple Part I
Monetary Issues Made Simple Part II
Hair of the Dog?
Microloans and the Community Reinvestment Act
The Reagan Lesson
CNN's Keynesian Nonsense
The Real Reason for the Bailout
An Analogy From Past Inflation
Why"Negative" Economic Indicators Are A Good Thing
Explaining Past Crashes
The Inflation Engine
A Reason to be Afraid
Defying Nature
My How Things Change
Alan Greenspan's Hubris
Weimar Republic Here We Come!

If you want to read more, by following the links, and the lists of articles in the postscripts to some of these articles, you should be able to find my older and more obscure posts.