Inflation has many negative, often unnoticed, consequences for an economy.  This is one example from Rothbard’s Chapter 12, which deals with credit expansion and business cycles, of Man, Economy, and State.  Businesses can unknowingly consume their capital in an inflationary environment.  Capital goods purchases are recorded at cost.  When finished goods are sold later, they are recorded with an inflationary gain.  The seemingly profitable business might consume the profits they believe have been earned above what they need for capital replacement.  However, when it comes time to replace the capital, it will also be inflated and the business will realize that its profits were illusory, and it had unwittingly been consuming its capital.

The recent housing boom provides a good example of capital consumption.  Home prices soared, causing American homeowners to feel wealthier.  They used this wealth to finance purchases of consumption goods, much of them imported.  When housing prices fell, people realized they had been fooled by the effects of monetary inflation on the housing markets and had been consuming capital all along.

This illustrates the importance of capital theory in any understanding of the way manipulations of the supply of money and credit can cause relative distortions in the capital structure.  In a world free of government and bank credit manipulation, the capital structure would be arrayed in conformity to society’s time preferences, where any investment would have to be financed through saving, which means putting off consumption now for more consumption in the future.  The ratio of the price of current goods and future goods provides the natural rate of interest and is a direct result of the collective time preferences of consumers, savers, and investors.

When interest rates and the supply of money are manipulated, people are fooled into thinking that they are richer and can afford to spend more when their assets rise in value, when in reality they are increasing their time preference by consuming their capital.  This is the economic boom period.  The bust follows when assets must be liquidated in order to finance the increased consumption brought on by the illusion of prosperity.