20.1 Inflation

The monetarist view

The Monetarist school emphasises the relationship between the quantity of money and the general price level. Milton Friedman famously stated that “inflation is always and everywhere a monetary phenomenon”, meaning that sustained inflation occurs when the quantity of money grows persistently faster than the output of goods and services (see The Counter-Revolution in Monetary Theory).

This is fundamentally a long-term claim. Short-term changes in spending, production, credit conditions, supply, and the adjustment of wages and prices can obscure the relationship between money and prices. Over a sufficiently long period, however, those transitional effects can be set aside. All other things being equal, if there is N times as much money competing for the same real output, prices will eventually be N times greater. Each unit of money represents a correspondingly smaller share of the available goods and services.

A long-term United States example

The longest current Federal Reserve M2 series begins in January 1959. The following compares its endpoints with the nominal GDP figures closest to the same dates. Nominal GDP is the dollar value of production measured at the prices prevailing in each period.

Over this period, M2 increased approximately 81-fold, the nominal value of annual United States production increased approximately 64-fold. M2 is a stock and annualised GDP is a flow, so the multiples need not be identical. The simple point is that over a long period, a very large multiplication of the money supply was accompanied by a similarly large multiplication of the nominal value of production.

A one-time multiplication of the money supply therefore produces a higher price level after adjustment. Continuing inflation requires the money supply to continue growing relative to real output and the public's demand to hold money. Short-term disturbances may mask or delay that long-term result, but they do not overturn it.

From this perspective, VoTa cannot produce long-term inflation by expanding the supply of Central Bank currency. After its initial distribution, the number of Central Bank currency units is fixed: the Central Bank cannot create additional units, and commercial banks cannot create Central Bank currency when they lend. Supply shocks or changes in the demand to hold currency may still cause the price level to move, but a one-off increase in prices is not continuing inflation. Without continuing monetary expansion to accommodate such increases, they cannot become a persistent rise in the general price level on the Monetarist account.

Tax choice redirects aggregate demand

To first order, tax-choice spending does not change aggregate demand. Let \(T\) be an amount of consumption tax collected and directed to public services, \(D_{\mathrm{private}}\) private demand, and \(D_{\mathrm{services}}\) demand from public-service providers. Relative to the position without that tax and expenditure, taxation reduces the purchasing power available for private allocation by \(T\):

Public-service providers receive and spend the same amount, adding \(T\) of demand elsewhere:

The first-order change in aggregate demand is therefore zero:

Tax choice changes the composition of demand rather than its total nominal value. It redirects purchasing power and real resources from the goods and services taxpayers would otherwise have chosen towards publicly funded services. No additional Central Bank currency is created, and the State cannot borrow to spend more than the amount collected.

This equality is a first-order result, not a claim that every economic consequence cancels. Private consumers and public-service providers may spend at different rates, purchase different proportions of imports, or demand resources with different supply constraints. Taxation and public services can also affect incentives and future productive capacity. Tax choice may therefore raise prices in sectors receiving redirected demand while reducing prices or activity elsewhere, but it does not create the additional economy-wide purchasing power associated with deficit-financed or currency-financed expenditure.

Supply-side price increases

Prices can also rise because the supply of an important product falls or its cost of production increases. The 1973–74 oil shock is a prominent example. Production cuts and the Arab oil embargo nearly quadrupled the price of oil, from $2.90 per barrel before the embargo to $11.65 in January 1974 (see Oil Shock of 1973–74). Because oil was an input into transport, agriculture, manufacturing, heating, and electricity generation, the higher cost propagated through the production and distribution of many other goods.

Food illustrates how widely an energy shock can spread. Farms use energy for machinery, irrigation, fertiliser, and other inputs, while food also has to be processed, packaged, refrigerated, stored, transported, and marketed. The UN Food and Agriculture Organization reports that agrifood systems use about 30 percent of the world's available energy and that 70 percent of the energy used within those systems is consumed after the farm gate (see Energy: facts and figures). This does not mean that food is “70 percent dependent on oil”, but it does show why higher fossil-fuel prices can affect food prices at many stages of the supply chain.

The appropriate response to a supply problem is to address the supply problem. Depending on its cause, that may mean obtaining oil from alternative suppliers, developing additional sources, using energy more efficiently, or substituting other forms of energy. Creating more currency does not create the missing oil or energy. It merely allows more money to bid for the diminished supply and risks turning a relative-price adjustment into broader monetary inflation.

In a market, a higher price communicates scarcity and increases the potential return from solving it. Producers and investors therefore have an incentive to expand supply, improve efficiency, and develop substitutes. Under VoTa this response can occur through both private investment and publicly funded services. Taxpayers can change their tax-choice allocations as circumstances and priorities change, directing funding towards research, infrastructure, emergency reserves, or other services that help remove the constraint. Tax choice is not tied to an election or an annual government budget: individual allocations can change continuously, allowing collective funding to respond to new information just as private spending and investment do.

Fiscal dominance and political inflation

Inflation can become politically attractive when a State can finance expenditure by creating currency. It allows spending to exceed taxation without asking taxpayers to bear the cost immediately, while the resulting loss of purchasing power is dispersed among currency holders. The temptation is particularly strong during wars, emergencies, persistent budget deficits, or when a heavily indebted government benefits from reducing the real value of its debts. If monetary policy is subordinated to those fiscal demands, restraint by the Central Bank eventually becomes difficult or impossible. At the extreme, repeated issue of currency to meet government obligations can culminate in hyperinflation.

VoTa removes this conflict rather than relying on officeholders to resist it. The State cannot borrow, the Central Bank cannot create currency to finance expenditure or purchase government debt, and public services can spend only the tax funding directed to them. The currency supply therefore cannot be expanded to conceal the cost of a war, emergency, failing service, or politically popular programme. Citizens must confront the real cost through their tax-choice allocations and decide which uses of limited resources take priority.

Inflation expectations and long-term planning

Expectations can propagate an inflation that has already begun. Workers seek larger nominal wage increases, suppliers raise quoted prices, lenders demand an inflation premium, and businesses shorten contracts or index them because they expect money to lose purchasing power. Those precautions are individually rational, but they can make inflation more persistent and make long-term calculation more difficult.

VoTa provides an unusually simple basis for expectations: everyone can know that the number of Central Bank currency units will not increase. No election, emergency declaration, policy meeting, or lobbying campaign can alter that rule. This does not guarantee that every price will remain constant, because productivity, supply, and demand for the currency can change. It does, however, remove uncertainty about future monetary dilution and the need to predict how officials will react. Saving, lending, wages, pensions, and long-term contracts can be negotiated against a currency whose nominal supply rule is stable and publicly verifiable.

Monetary-policy errors and time lags

Discretionary monetary policy requires officials to estimate the economy's productive capacity, the neutral interest rate, future inflation, and the delayed effects of their own interventions. Those quantities cannot be observed directly and estimates are revised as new information arrives. An intervention intended to address an earlier problem may therefore take effect after conditions have changed, amplifying rather than moderating the next movement in prices and economic activity. Monetary policy can also be influenced by pressure to produce a short-term boom before an election while leaving its inflationary consequences until later.

VoTa does not attempt to make these forecasts more accurately. It makes them unnecessary for management of the currency supply: there is no policy interest rate, open-market operation, quantitative easing, or discretionary creation and destruction of Central Bank currency. This means VoTa also gives up attempts to fine-tune aggregate demand through monetary policy, but it eliminates the policy-induced cycles, delayed over-corrections, and political manipulation that such discretion can produce. Prices, saving, lending, investment, and tax choice respond directly to current conditions instead.

Asset-price inflation

Particular sectors can experience rapid price inflation during an asset bubble, especially property and share markets. By far the most important driver of modern asset bubbles is the ability of commercial banks to create new deposit money when they extend credit. Newly created purchasing power can be used to buy assets, raising their prices; the higher valuations then provide collateral for still more credit and allow the bubble to feed itself.

This mechanism does not exist under VoTa. Commercial banks cannot create Central Bank currency: every loan of it transfers existing currency from a lender to a borrower. Asset prices can still rise and speculation can still occur, but credit cannot manufacture the additional Central Bank currency that makes a bubble self-financing. The mechanism and historical examples are discussed further in 20.7 Commercial banks and private money creation and 20.8 The boom causes the bust.