The connection between inflation and recession

Why does inflation turn into recession? How might a big inflation ruin an economy? Why do governments, East and West, socialist and capitalist, Chinese and American, that already know and at least in theory agree with much of what I am about to say, yet undertake to make matters worse by acting in ways that make more damaging the factors that connect inflation with recession?

The answers have to do with the services or what are classically listed as the functions of money and the unfortunate reality that governments believe they can perform those functions better than do monetary institutions that are “natural” and universal. Governments act to entangle money’s functions with governments’ desire to “improve things.”

Let us lay down an axiom. Money is a “public good.” That is, money, or more accurately the functions of money, are only useful in society: Robinson Crusoe, the stranded sailor in Daniel Defoe’s fictitious account of him, before he meets his Man Friday is utterly alone and has no need of money or its functions.

These are the social functions of money: It is a means of payment, a store of value, a unit of account, allowing records to be kept of who owns, owes or has promised what degree of value and in what terms an obligation may be settled, a measure of relative values (how many hamburgers does one give up to buy a pair of shoes?), a standard of values, today and in the future (it can give an idea of the value of a basket of goods, a mixed  “bag” of things including a week’s worth of groceries, a ticket to the movies, a day’s rent of an automobile and a kiss from a woman (or man) of easy virtue – the basket including a conditional guarantee of the future delivery of one or another product.

A critical element in the list above is that these services of money operate socially between persons or economic entities. A simple way of saying it, if we can eliminate the political element the word introduces, is that that these  are the services essential for the existence of a market for the exchange of goods and services.

Such a well-serviced  market renders the goods exchanged within it portable (in a virtual sense), alienable (goods pass from hand to hand), divisible (virtually: you may break off a piece of a house by renting it for a month) and insurable (a third party can be paid to make you “well again” if a trade fails). 

Money in this case means the social institutions that generate services necessary to the operation of a market. Money allows the concept of ownership to come into being. A thing will only have money value if its possessor knows how much his possessions are “worth” and his status as owner is secure. Goods may only be exchanged if the status of owner is also exchanged.

Markets plus contracts (defined below), East or West, in China or America, allow a kind of economic magic to be done, whereby a plumber or an electrician, working in the heart of a great sprawling city, out of sight even of a blade of grass or the leaf of a tree, may convince a farmer on a distant field or a fisherman floating in a faraway sea, to provide the morning eggs or the evening poached salmon with which the city man supports his wife, children and self.

A contract, in China or America, changes a mere promise into a binding mutual obligation, consisting of an offer, acceptance, reliance and consideration/compensation (OARC). Just what on-the-ground actions comprise an OARC Involve the services of monetary institutions, including banks, accountants, lawyers and judges. 

Money, when in ancient times it became an element of compensation, moved civilization forward when it made it possible for litigants in a dispute over whether a doctor whose best efforts could not repair damage to the eye of his chieftain was able to pay a money fine rather than lose his own eye in compensation.

The economic miracles made possible by the services of money multiplied productivity.  Monetary services made possible the division of labor essential to the appearance of the industrial revolution. The division allowed city men to acquire eggs and salmon when their great-grandfathers, living on self-sufficient isolated farms, or, going further back in history, were hunting and gathering in family units, could only eat what they could kill and preserve.

The division of labor, followed by specialized production and resulting improved productivity, requires those monetary services discussed above. 

Inflation is not just about rising prices. It is a situation when monetary services are no longer durable, secure, reliable or insurable, or are no longer in existence. During inflation, price ratios change in unexpected and unforeseen ways and times. 

Inflation is a time when the money price of an hour’s labor buys only two dozen eggs, not four dozen. Inflation means a retired electrician who invested his life savings in government bonds discovers he cannot afford his rent, and so must move into his daughter’s house, reversing the natural order of things.

Inflation means the level of economic satisfaction everywhere is less, the payoff from showing up for work every day is nil, the rationality of getting an education whose after-graduation earning power is uncertain or unknowable and metaphorically it is just not worthwhile to get up in the morning for work. That is recession.

In short, recession may be defined as a serious and long-lasting diminishment in the efficient workings of markets, in the rationality of specialization, in the security of ownership, and in the predictability of the economic future. These same things are the consequence of inflation. They are the essence of the failure of the many functions of money. Inflation and recession are two sides of the same coin.

Why do governments, East and West, create and aggravate the situation called inflation/recession? Think about each function of money and you will see how it may benefit government to subvert it or at least channel it into the service of the interest of government as opposed to the interests of economic entities who pursue their own, non-governmental interests.

The government interest involved may be rational in that it may serve the common good.  Government’s goals may be shared by at least some part, some powerful part, of the citizenry. The issue is that one or another of money’s services is impaired, sometimes to the point where overall “utility” of specialization and trade is diminished, real income is reduced, and some degree of inflation/recession (conceivably an acceptable degree) is the consequence.

But whatever the government’s motivations, the consequence of induced inflation is induced recession.

Let us go through the list of just how induced impairments of money’s services brings about a loss of real income.

Two economic entities may employ money as a means of payment between themselves because both are better off after the exchange than before. There is a surplus of value created. (It is a non-Marxian surplus value, but it is fun to use the phrase.) 

Government may capture for itself some of that surplus by means of a sales tax that raises the price to the buyer and lowers the return to the seller. But because of the surplus, both players will go forward with the exchange, and government finds a clever way to tax, to finance, its operations (it thinks) without too much damage to private motivation to specialize and consequently to continue to trade.

Government convinces itself that the goose that lays taxable eggs is not killed, only hurt.

Unit of account 

Records are essential, since trade is almost never immediately concluded, since future obligations are commonplace, since memories are faulty and since later-on third party interventions needed to resolve disputes require them. But governments in possession of such records may easily apply taxes to surplus value or investigate what it considers to be wrongful exchange. 

Once again, the non-governmental entities whose records are thus used “against them” lose motivation, or are inclined to hide records, keep bad records or go without records, always resulting in lower real utility income, as they measure it. (Government might have a different metric.)

Store of value 

Savings are essential to specialization. A farmer produces his entire year’s income in three weeks of harvest and three days of selling. He must save and spread out his purchasing power over the entire rest of the year. 

A professor may spend 50 years of his life-giving lectures, in the hope and belief that he will be able to pay his grocery bill, his rent and his entertainment costs out of his promised pension savings. 

In both cases, short-run or long-run inflation may deny farmer or professor some fraction of society’s general “fruits of labor” allowing government to “dip into” the metaphorical surplus storehouse of such fruit and take and “eat it” in the name of government interest.

Ownership and standard of value

Famously, socialism is defined as ownership by the state of the means of production. That definition, at least in its most rigorous and inflexible form, is rarely encountered today, and does not accurately or completely describe the situation in either China or America.

But it is by means of some sort of government presence in the economy that we may have a proxy measure of the degree to which governments (anywhere) affect or possibly “control” the means of production.

The ratio of government spending to GDP is high almost everywhere. According to Trading Economics’ website, in France it is 59.2; Cuba 58.8; euro area 52.4; Japan 47.25; UK 44.7; US 43.64; Switzerland 34.5; South Korea 31.15; and India 15.93. (I don’t believe the last number, since the Indian bureaucrats seem to be everywhere there.)

The website for Statistica says the ratio of government spending to GDP  in China in 2022 is 33.76%. This metric says China is more capitalistic than Switzerland. But of course, China is a socialist state, and there the government controls a great part of its economic activity. 

Rather than looking at spending ratios, my monetarist analysis of why socialistic governments use inflation, or at least use their influence over the pricing mechanism, to such a degree that the “economic records” function and the “standard of value” function are impaired to the point where inflation/recession arises.

It is because future-looking investment choices cannot easily be made despite strenuous efforts to plan. As Ludwig von Mises put it (in a slight paraphrase from Investopedia): “Socialists are unable to perform any real economic calculation  without a [monetary] pricing mechanism. Accurate factor costs (that is, input costs in money for land, labor and capital) … [do not exist]. Without accurate factor costs, no true accounting may take place. Without futures markets, capital can never reorganize efficiently over time.”

Not only socialist governments mess with factor markets, much to the distress of players who oversee future investments. US President Joe Biden pushed hard on the constitutional limits of his powers when he and members of his administration acted to halt, delay, tax, regulate and politically manipulate the real costs and prices in many kinds of investment markets, ranging from energy to fisheries. 

(Although a recent White House dinner featured Maine lobsters sautéed in butter, surprise new regulations to “protect whales” in the Gulf of Maine have raised costs for lobstermen there.)

So we see that the present situation, consisting of a mixture of recession and inflation, is a choice, largely made by governments, East and West. It is not an act of God. It is not a matter of supply chokepoints. It is not inevitable (except insofar as governments find it in their interest to interfere with the services of money).

Alas, since the interests of Government (with a big G) are everywhere and have always been imperfectly aligned with the interests of the non-government players in the economy, untimely intervals during which this two-legged creature inflation/recession walks about will continue to appear. Let us hope the damage is not too great.

Tom Velk is a libertarian-leaning American economist who writes and lives in Montreal, Canada. He has served as visiting professor at the Board of Governors of the US Federal Reserve system, at the US Congress and as the chairman of the North American Studies program at McGill University and a professor in that university’s Economics Department.