An Explanation and Evaluation of Inflation
There are many aspects to inflation that you must understand to understand the big picture, so we will go slowly. Please note that anytime I site “the government”, I am referring to the federal government of the United States of America.
Inflation Defined
Inflation is the phenomenon by which a currency (the U.S. Dollar, or USD, for our discussion purposes) becomes devalued because of dilution. In simpler terms, it is the process by which a dollar becomes less valuable as more dollars are added to the system. For example, if there are ten dollars in an entire system and you have two of those dollars then you own 20% of the system’s value. If ten more dollars is added to that system, there is not an increase in production and you still only have you two dollars, then you now only own 10% of the system’s value, essentially devaluing your worth to half of what it was before. Since there is twice the money in the system and the system has the same amount of productions as it did before, every good and service will now cost twice as much, meaning you can only buy half of what you could before. In essence, your two dollars in the new system would only be worth one in the old system.
Despite its simplicity, this model can be fit to the entire United States to give us an idea of how inflation works in an entire nation. Granted, this is a big jump because the USD is the most widely held form of currency in the world and there are trillions upon trillions of them held across the world. However, it still stands that for every dollar that is added to the system every other dollar is reduced in value by a small fraction; every dollar can by slightly less goods or services every time a new dollar is added to the sum.
Who done it?
So who is adding money to the system? Simple answer: the government. We all know that the U.S. government is the only body that can legally print USD. But how do they put the money into the system? There are two ways that the government distributes the money they create, and you have probably heard of both of them.
The first is through the Federal Reserve, with a pit-stop at the Treasury. Surely you have heard or read in the news of the Federal Reserve (or the “Fed”) lowering or raising rate—you might have wondered what exactly this rate is and how it affects anything. Well, this rate they are typically referring to is called the Fed Funds Rate, or more informally, the overnight rate. Here is where things can get confusing. For the sake of keeping things simple, the Fed Funds Rate is essentially the annual rate at which one bank will lend another bank money for one night through the Federal Reserve (hence the term “overnight rate”). So, if a bank borrows from the Fed at the Fed Funds rate they pay 1/365th of whatever the Fed Funds Rate is to borrow that money for one day. The reason for this is unimportant to our analysis of inflation, it is simply important to know what the Fed Funds Rate is. So now we know what it means when they say “The Fed lowered rates to 2% today.” How does the Fed go about lowering that rate? Contrary to what the media leads us to believe, the Fed does not simply set the Fed Funds Rate at the drop of a hat. That is, the Fed cannot simply say, “Today the rate will be 4%,” and poof, there it is, 4%. It is more complicated than that—the Fed must manipulate the market. The Fed does this by putting money into the banking system. Every large bank holds many federal government securities (aka T-Bills, T-Bonds, etc.) that are essentially notes stating that the federal government owes the owner of that note a certain amount of money plus interest to be paid on a set schedule. These government securities are how the government borrows money to meet their own obligations. The Fed is able to put money into the banking system by taking money from the Treasury and buying the government securities that banks hold. This transfers large amounts of cash to banks, and a bank’s entire duty is to lend cash. So, when a bank sells its government securities to the Fed they are flush with cash that they look to lend. Since many banks have much more cash to lend there is much competition to lend the cash they have all come into. This competition will drive down rates in the market. After all, if hundreds of banks are trying to lend to the same borrowers, those borrowers will request the lowest possible interest rate. In this sense, the Fed is successful in lowering not only the Fed Funds Rate, but also the interest rates throughout the economy. To recap, every time the Federal Reserve “lowers rates” they are putting more money into the system and every time they “raise rates” they are taking money out of the system.
The second way that money is added to the system is through government spending. There are three ways the government raises money to pay for their spending. The first is the old fashion way, they levy taxes. The second way is through borrowing money by issuing government securities such as Treasury Bills and Treasury Bonds. Individuals and institutions around the world (but primarily in the U.S.) will purchase these securities—effectively loaning their money to the government for a very low interest rate. The rate is so low because the U.S. government is perceived as being very likely to repay their debts—the most likely in the world according to most. This debt is usually paid by issuing more debt to service the interest and principal on the old debt and eventually the U.S. deficit is at about $9.5 trillion, where it stands today. The third way, the way most people don’t realize, is by creating inflation. One thing that is important to understand is that each of these methods of raising money to spend that the government uses are ultimately financed by Americans. Not only tax-paying Americans (though they do finance the most because they pay for the taxes and the debt), but all Americans who use the USD, which are virtually all Americans—rich and poor.
Revealing the Magician’s Trick
So how does the government pay for their spending with inflation? The simple way to look at it is that the government takes money the Treasury creates and spends it, whether it is on subsidies for wheat or Apache helicopters purchased from Boeing. The more complex way is through the repayment of debt by the Treasury. When the United States issues debt in the form of government securities it has to eventually pay back those obligations in the form of cash. The government has issued huge amounts of government securities to individuals and institutions over the years so it is a virtually constant stream of outgoing payments from the government to the holders of these securities to settle the government’s debts. When the time comes to settle the debt, the government can pay the debts in the same ways it pays for anything: taxes, raising new debt, or simply creating money (note that I don’t say “printing money” because in reality only a very small percentage of US dollars are ever printed, most are simple kept track of electronically in today’s world). When the Treasury does decide to simply create money to pay the federal government’s debts it adds money to the system that did not exist before that point and thus makes every existing dollar less valuable by some fraction.
So why would the government create new money to pay its debts and thus create inflation? Let’s start by looking at the other two ways the government can pay for their spending. First are taxes. The government has the power to levy all kinds of taxes to pay for its spending—and has not been bashful about doing so over the last 80 years. Regardless, telling your constituents that you wish to put heavier taxes on their incomes, businesses, purchases, etc. is a tough thing to do if you want to be in office for any extended period of time. As such, calling for further taxation is a very unpopular choice among politicians and is usually a last resort. The second possibility is to raise new debt to finance spending. While this is not as unpopular as levying new or heavier taxes, it is still unpopular amongst voters. Think of how often you hear the national deficit or national debt mentioned in political circles. Another big problem, from a politician’s standpoint, with raising government debt is that it eventually has to be paid back via taxes, more debt, or simply creating money. So, while more politically feasible than further taxation, debt still is not the most desirable means of government fundraising in the eyes of politicians. In comes the creation of new money and eventual inflation. Via the Treasury, the federal government and politicians have a means of simply creating money to pay for their spending. The plusses of this situation, for a politician, is that they can spend more money on their constituency, earning more votes, more time in office, and more power all while not levying any more taxes on their constituents and not borrowing a dime of money; quite the carrot to be dangled in front of the politician. The downside of the creation of money to fund spending is it will eventually create inflation and the USD will be worth less. Here’s the real sweet upside for the politician—the inflation will typically not set in until approximately six months after the quantity of money in the system is increased. That means that the government can create and spend $100 today and it will buy $100 worth of goods and services. However, six months from now that $100 will be worth something less than the $100 it is worth today and will be able to buy less goods and services. Therefore, the government can create and spend money for full value and not have the value fall until they have already spent it. Thus, the government loses nothing by creating money and only the people holding the money at the time of its inflation, chiefly the American people, lose value. Ah, the perfect solution for the over-promising, under-delivering politician.
The Inflation Tax
Because the government is able to create money and spend it at its full value, thus inflating the currency in circulation, it is able to levy an invisible tax on every American citizen. In this way, if the inflation for a given year is three percent (3%), then it can be said that the government taxed the every holder of the USD roughly three percent (3%) of each dollar’s worth in that year. So, the United States federal government is able to spend much more than they would ever otherwise be able to spend and Americans are the ones that are chiefly taxed for that spending, and they are taxed without representation in direct violation of the Constitution of the United States of America.
United Scapegoats of America
But wait, we haven’t even gotten to the best part yet. Not only can the government create money and spend it at its full value, only to be devalued once it is in the hands of the American people, but they are then able to give reasons as to why that money is worth less that have nothing to do with them creating money and fueling inflation. In essence, the thief gets off by pointing the finger at another, entirely innocent bystander.
Here is one you have probably heard, “Oil and other commodity prices rise relentlessly, spurring runaway inflation not seen since the 1970s.” That is a quote from a Wall Street Journal article titled “The Economy: How Bad Can It Get?” Despite my relative enjoyment of this particular newspaper, they are repeating what has been repeated for decades now. As oil goes, so goes inflation. If the price of oil goes up then it is because of some ungodly nation in the Middle East or even the greed and gluttony of the American people or perhaps it is that China is using more oil.
The idea that oil fuels inflation (pun intended) spawned in the 1970s after OPEC temporarily cut off its supply to the United States. During that time oil prices jumped and so did inflation. This created a temporary correlation between oil and inflation in the 1970s (the correlation being that oil went up and so did inflation). However, any elementary statistician will tell you repeatedly that correlation does not indicate causation. That is, just because two things happened at the same time does not mean one is the result of the other. There is no doubt that by OPEC not supplying oil to the United States that it caused an increase in the price of oil, but to believe that this increase in the price of oil caused inflation is a fallacy. The drop in the supply of oil and the resulting increase in the price of oil happened to come at the same time as the United States government was pumping huge amounts of money into the system. This increase in the monetary supply is the true cause of the runaway inflation of the 1970s. Ironically, the Federal Reserve attempted to control inflation and lower interest rates in the market during this time by putting more money into the system, which only fueled the fire. Furthermore, despite the correlation between oil and inflation in the 1970s, this began to deteriorate after the 1980s. From 1972 to 1979 the nominal price of a barrel of oil increased from $3.50 to $40, and average annual increase of 149%. From 1973 to 1980 the Consumer Price Index (“CPI”), a popular measure of inflation, increased from 41.2 to 86.3, an average annual increase of 6.4%. In the 1990s oil prices shot up rapidly once again as a result of the Gulf War. Crude oil prices roughly doubled over a period of six months from around $20 a barrel to around $40 a barrel, 200% annualized. Despite this rapid increase in the price of oil, the CPI remained relatively stable—increasing from 134.6 in January 1991 to 137.9 in December 1991, roughly a 2.5% increase. This separation in the relationship between oil and inflation was even more apparent the period from 1999 to 2005, during which the annual average nominal price of oil rose from $16.56 to $50.04, an annual growth rate of 40.4%. Conversely, the CPI rose from 164.30 in January 1999 to 196.80 in December 2005, and annual growth rate of 3.3%. This data serves to show us that even though inflation increased rapidly in the 1970s at the same time that oil prices increased rapidly, great growth in the price of oil does not necessarily create large growth in inflation.
It seems apparent that oil does not control inflation. In fact it may be the opposite. There is no doubt that oil reacts to market demand and supply, but one thing we might be able to take away from this is that inflation also contributes to increases in the prices of commodities. That is, as the dollar becomes less valuable it is not able to purchase the same amount of any given commodity as it was once able to (i.e. oil, gold, food, etc.).
The point is this, whenever there is significant inflation the government will undoubtedly blame it on everybody but itself. The example shown regarding the government blaming inflation on oil is just one of many tricks up their sleeve. There is only one long-term cause of inflation and that is an increase in the money supply that outpaces increases in production and the government is the only body with this power.
When I was a kid a milkshake cost the same amount it does today
So how do we get rid of inflation? How do we make sure a dollar today is worth a dollar tomorrow? It is simpler than you might imagine. The quantity of money theory eventually states that ΔP = ΔM + ΔV – ΔY where P represents inflation, M represents the money supply (how much money is in the system), V represents the velocity of money (a measure of how many times per year money exchanges hands), Y is output or GDP (total production in a country in any given year or period), and of course Δ represents the change in all of these variables. That is to say that the rate of inflation equals the change in the money supply plus the change in the velocity of money less the change in output, or GDP. Typically the velocity of money does not change much and is rather predictable. Therefore, if the velocity of money is held constant, or has a predictable rate of growth or decline, one can completely eliminate inflation by setting the change in the money supply equal to the change in the growth for any given year.
This is the only part you need to know: if the rate that the government puts new money into the system equals the rate of growth in an economy then there will theoretically be no inflation (thank you Milton Friedman).
Now we encounter the problem of how to guess what the growth rate of the output will be for a year. This, admittedly, is impossible to do precisely. However, we can make a pretty close guess by taking the moving average of the GDP growth of our country over a set period of time and weight it more toward recent years to find a fairly accurate prediction of the growth rate of the GDP. If this was instituted it may not make inflation at a perfect zero percent, but it would certainly get it about as close as we possibly can.
The Benefits and Consequences of Ending Inflation
Ending inflation is something like getting a fat guy to go to the gym every day. For the first few months he is not going to see any results and he is going to feel the pain of working out every day. However, if he sticks with it he will begin to slowly see results and soon enough he will be in good shape and will wonder how he ever lived without working out.
There are certainly pains associated with ending inflation. Primarily, when the government cuts off the supply of money to steady its growth there will be an initial shock in which banks and institutions are less willing to lend money and will require higher rates of interest. Additionally there will be a few months when there is still inflation because the market will still have to adjust to the prior monetary injections by the government. When institutions do not lend money businesses do not expand and some people lose their jobs and others do not get hired. These are the months that the fat man at the gym wonders why he ever began working out and dreams of a bucket of drumsticks from KFC.
If the government were to stick with it and ride out the pains of ending inflation then it will pay great dividends. Responsible monetary policy and low inflation means no business cycle and continuous, steady, healthy growth. That is, we would not have the recent tech bubble and certainly not the recent housing bubble. Instead of having wild booms followed by wild recessions in the economy, we would have a more linear line of growth. This would benefit virtually everyone in an economy because it would create stability and confidence. Banks and investors would not have to include inflation buffers and market risk premiums onto their required rates of return. This would inspire more investment into businesses, which means more, higher paying jobs and more consumption and the beautiful cycle of the free-market is unleashed to run unbounded.
Conclusion
Ending inflation is like battling the body of a snake I call government. You may wound it by ending inflation via the means I have laid out above, but you will not kill it. The real cause of inflation is the government’s unbridled spending and lack of monetary responsibility. If you wish to take one thing away from my writings let it be this: to kill the snake you must cut off its head—this snake’s head is government spending.
For more on my complete onslaught against government power and spending and the restoration of liberty to the people of the United States please check back for future articles. Thanks for reading and please open up any debate you may have!
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I still don’t understand how this inflation business works. It seems that it’s been stated too simply here. It may be the case that this was worded this way because this is just a short blogz aimed at giving a baseline of understanding to the layman who doesn’t know virtually anything about economics. If so, kudos, I think it did its job for this uneducated reader.
I guess my question is how can the value of the dollar make a difference if it changes for everyone at the same time? Wouldn’t the difference in the dollar’s value make everyone’s dollar a little bit more valuable or a little bit less valuable at the same time and make the difference in value proportional for all dollars?
Like wise, if the amount of dollars in a system is increased in proportion to the product being produced, the dollar value wouldn’t change, would it? If it doesn’t change with proportional increase in production, then how do different currencies (all being an authorized note from a government representing a note for trading goods) have different fluxes of value at different times? How have we ever been anything BUT a global market?
If inflation occurs because of the amount of dollars in a system, but the dollars in the system take time to actually change value, then it isn’t the amount dollars in the system acting alone on the dollar value, is it? Could a market’s knowledge of the increased dollars in a system affect the system’s currency value, if so, why actually print more money than is needed to be in proportion with production? Why not just say, “hey, we pumped more money in, your dollar is worth less now?” Saves money AND trees. Beat that!
All this stuff being said, try and remember I know nothing about economics and am just asking questions that seem legitimate based on what was written here.
This is actually a very good question. I think your main idea is that if money is worth less then it offsets because though the merchant has to pay more for his inventory, he can sell that inventory for a higher price because of the devaluation of the currency. That, you are absolutely correct about and that is the process by which inflation spreads through an economy. The problem is not with the transaction of goods; goods maintain their value despite inflation – they just do not maintain their price.
When a currency loses its value the people it affects are all those people holding that currency during that period of time. That is, imagine you have a bank account with $100 in it. Today that account is worth $100 worth of goods. Tomorrow there is a sudden devaluation of the currency and each dollar is worth 1/10th of what it was previously. So, though you still have $100 in your account, it is only worth $10 of goods. You essentially lost $90. More accurately, the government essentially spent your $90 without your consent and was still able to make you pay for it. So, the people that are harmed by inflation are the people that have the currency that is being devalued. Given that most everyone in this nation has some sort amount of money at any given time, essentially everyone is hurt by inflation. Inflation also has the effect of dramatically decreasing the value of interest-bearing securities and notes. If I lend the nation $100 for an interest rate of 3% by buying a Treasury bond then the rate of inflation increases to 5% per year, I am actually losing money on my investment. You can imagine how banks, pension funds, insurance companies, and any other institution that holds a great deal of cash and/or interest bearing securities would be dramatically hurt by this. Furthermore, wage increases tend to lag behind inflation, essentially making it so you can’t buy the quantity and quality of goods with your wages you would otherwise be able to. However, I don’t see the wage lag as much of a problem in an efficient market where wages are free to change.
“Like wise, if the amount of dollars in a system is increased in proportion to the product being produced, the dollar value wouldn’t change, would it? If it doesn’t change with proportional increase in production, then how do different currencies (all being an authorized note from a government representing a note for trading goods) have different fluxes of value at different times? How have we ever been anything BUT a global market?”
Another great question. You are absolutely correct that if production in an economy increases at the same rate as the money supply then there will be no inflation or deflation. Different currencies, however, are controlled by different central banks. Ours is called the Federal Reserve, the UK’s is the Bank of England, Japan’s is the Bank of Japan, and so on and so forth. Every central bank is not necessarily of the opinion that the increases and decreases in the money supply should math those of the GDP. In fact, most seem to be of the opinion that money should be created whenever their government needs to spend it. The point is that just because country X follows a responsible monetary policy does not mean that country Y will as well. As such, as country Y’s currency becomes inflated it will become less and less valuable as compared to country X’s. This is why you see every currency valued in terms of one dollar. For example, the dollar is now worth about 87 Japanese Yen as of today, whereas a year ago it was worth about 113 Yen. This simply means that the US dollar has lost significant value compared to the Japanese Yen. Different central banks make different decisions and this creates a situation where two currencies are rarely not changing in value when compared to one another.
“If inflation occurs because of the amount of dollars in a system, but the dollars in the system take time to actually change value, then it isn’t the amount dollars in the system acting alone on the dollar value, is it?
Yet another very good question. You are right that it takes a while for an increase in the amount of money in a system to create inflation. However, this does not necessarily mean that there is some other force creating inflation. It is something like throwing a bucket of water down a long slide, we wouldn’t expect that right as the water is throw that it will come out the bottom, rather it takes time to wind through the slide to reach the bottom. Using an example above, pretend that the government writes a check to Boeing for $500 million for an order of Apache helicopters. This money did not come out of a tax pool or from debt raised by the United States, but it was simply money created out of thin air that the government then gave to Boeing. To Boeing that money is worth the $500 billion they were asking for the helicopters so they happily accept it and cash the check. That $500 billion is then paid out to employees, suppliers, and stockholders. Those people then spend the money on other goods and the process continues perpetually. Right when the government gave Boeing the $500 billion of created money there was $500 billion more in the system. However, the market did not know this at the time, so that $500 billion was still worth $500 billion, because fiat money is only worth the amount that a market thinks it is worth. Because people are very intelligent and markets are very efficient, the market will soon notice that there is an extra $500 billion in the system and the currency will be worth that much less. So, the government was able to spend $500 billion and get $500 billion worth of goods, but once the market sees that this has happened that $500 billion in currency will only be worth something like $450 billion worth of goods (to keep things simple). So, the holders of that currency slowly paid an inflation tax as the currency lost its value. As a result, Boeing will have to charge the United States $555 billion for its next round of helicopters because Boeing and the rest of the market now recognize that today’s $1 is no longer worth the same as today’s $1, and the process will start over again. Despite the market being efficient, the tracking of the value of a currency is very complex and requires some time to accurately determine. This process results in the lag we see between the point in which the government creates increases the amount of money in the system and the point where the inflation is realized. This then allows governments to blame inflation on something other than their own irresponsibility and theft – it is a very effective tool.
“Could a market’s knowledge of the increased dollars in a system affect the system’s currency value, if so, why actually print more money than is needed to be in proportion with production? Why not just say, ‘hey, we pumped more money in, your dollar is worth less now?” Saves money AND trees. Beat that!’”
Yes, the markets knowledge of an increase in the amount of currency injected into the system will almost immediately change the value of the dollar. This is why after the Fed announces that it will be lowering the Fed Funds target rate that the dollar falls in value relative to other currencies. The part that takes longer to figure out is when the government simply makes up its shortfall between tax revenue and spending by creating money. To respond to your question I think I need to clear up that when I say the government makes money that does not mean that they physically print hundred dollar bills. Most of the money in the world is transacted electronically and on paper, not with actual physical currency. Only a small fraction of the world’s money is actually in the form of physical currency. When the government “creates” money to send to Boeing it does so with electronic transactions, not physical cash. The problem lies in that the electronic currency comes from nothing and has no real value. It even has less value than the paper that $100 bills would be printed on. I appreciate your concern for trees, but unfortunately telling the market that there is more money in the system will not save too many trees.
Great questions, I’m glad there is interest in this.
“However, the market did not know this at the time, so that $500 billion was still worth $500 billion, because fiat money is only worth the amount that a market thinks it is worth.” So how does a market figure out how much the dollar is worth? I don’t mean to nitpick this too closely, but this is a pretty important point for me to understand if I’m going to be able to grasp any of this. If all that is involved with a product’s manufacturing and selling cost is the perception of dollar value, then what motivates people to perceive a high dollar value or a low dollar value? Likewise, if dollar value is all based on perception, then how can the government set tax percentages for different income brackets when money earned in the beginning of the year is potentially worth a different amount than the end of the year?
You have said that the government is the only institution that can create money, but the government can’t manufacture any products. Only people can do that. So every time a new product enters the fray, all other products then lose their relative selling power. This loss occurs proportionally to how strongly the product appeals to the consumers (assuming the new product isn’t perfectly ideal, which I’ll address shortly). If the government orders 500 billion dollars worth of Boeing helicopters via the treasury, it stands to reason that the amount of product in the market has been increased by an amount proportional to the increase in dollars (unless the government is paying too much or too little for the product). Since product number has been increased, the value of each product has decreased. The idea here is that the value of the dollar can’t matter in a free market where new products are constantly being manufactured and sold. Any value-imbalance in this system is equally shared by producers and consumers, so I still don’t get why inflation needs to happen or how it works against us (especially considering you said money’s velocity was fairly constant)?
It would be foolish to believe that a nation’s currency interacts in perfect harmony with all of its products, but I think it’s like you said, “Because people are very intelligent and markets are very efficient, the market will soon notice that there is an extra $500 billion in the system and the currency will be worth that much less.” If people in their respective markets are, on average, at least as smart as the people buying stuff via the treasury, they will start to understand that selling to the government at the expense of the people (which includes government employees and Boeing CEO’s) only hurts those whose product’s profit margin is less than average. So why does Boeing still sell their product to the government at the harm of everyone else? I think it’s because if Boeing’s products aren’t ideal (perfect), they’d better bet on their products being CLOSER to ideal than everyone else’s products. By that logic, they would be weathering the storm of losses better than anyone else and expedite the kill-or-be-killed end result of a free market economy. From that vantage, it seems like the government creating money out of thin air is expediting the natural economic process.
Imagine a product like a Boeing helicopter that was perfectly ideal in every way possible (this is impossible, but give me a break). The costs to manufacture the chopper are ideal (durability, quality, affordability) and its selling price is ideal, which leads to a perfectly ideal profit margin (ideal profit margin would include a dizzying array of variables that I don’t know/care to list, but it should be noted that both parties must still benefit). This ideal product, the Boeing helicopter, couldn’t have any interaction with the value of the dollar because it is perfectly priced to serve some specific function. In fact, this magic ideal helicopter couldn’t be affected by any increase or decrease in the value of the dollar OR the cost of manufacturing each helicopter. The further away you are from this “line of best fit,” or “perfect product line,” the more drastically your income is affected (both positively and negatively in value depending on which side your product tends to be faulty) by changes in product/dollar value. “If ten more dollars is added to that system, there is not an increase in production and you still only have you two dollars, then you now only own 10% of the system’s value, essentially devaluing your worth to half of what it was before.” It sounds to me that the Fed isn’t just arbitrarily creating money to cheat the people; it seems to me that our country is constantly increasing its GDP at varying and unpredictable rates, so once in a while, more money needs to be added to ‘balance’ things out.
Does this sound right? As I was reading your response, it all made a lot of sense, but if I’m wrong, and the government had been increasing the amount of money in the system without any other effect balancing it out, the dollar would have ceased to have any worth right after we got off the gold standard. People, the very smart and dynamic ones that have been selling helicopters like hotcakes on riseofreason.com, would see that the government is just creating money out of thin air with nothing to back it up. If we left the gold standard, but didn’t have another variable that was stemming the tide of “loaner doubt”, how would there be any confidence in the government’s repayment of T-bonds and T-bills? What would show consumers that the government had anything to back up what they said they were going to pay? After thinking about it, the government couldn’t guarantee anything after the abandonment of the gold standard. It turns out that the guarantee to pay debts was issued from the history of dynamic, creative, intelligent people who make up this country and our industries.
All of that being said, I can’t see why the flexibility that fiat money allows for is any better or any worse with or without inflation. Could you help clarify?
Again, all great questions. Markets determine the value of the dollar by the amount of goods it can purchase. One simple example would be if you wanted to buy a product in Japan. If you were to give them $100 for that product it would have bought you about 75% of what it would have bought you a year ago. This is created by currency traders whose lives are dedicated to determining the real value of currencies. They can do so through many different methods: looking at the money supply figures published by the Fed http://www.Federalreserve.gov/releases/h6/current/, the Big Mac index http://en.wikipedia.org/wiki/Big_Mac_Index, and of course their own algorithms and methods. Merchants cannot simply make up whatever price they wish to sell their products at because their business depends on the prices of so many other things in the market. Even a logger cannot simply charge $1 per tree because he still has to pay for saws, men, and trucks, each of which have a price that fluctuates with the market. Conversely, a logger also can’t charge $1 million per tree because some other logger will sell a tree for far less. There are really limitless means of realizing the impact of the dilution of the dollar in such a complex world. The best way is to consider smaller environments then grow from there. If a family traded Monopoly money in their household as a way of buying and selling time using the only television and the father went out and copied his monopoly money so that he could buy whatever he wanted then the price of the television use would skyrocket over time. There may seem to be no victims since everyone is simply paying a higher price for use of the television, but if one of the children had decided to save all the monopoly money they acquired over a period of months so that they could use the television for a longer period of time then that child would have essentially been left with nothing. Inflation essentially kills savings and that is the real tragedy of it.
I suppose some of the trouble comes from the question of how is a piece of paper worth anything more than just that, the paper? Really, it isn’t at all. However, everyone in this world believes it to be so it becomes worth something because even if I think it has no value I can still go to the store and buy things that I feel have value and simply exchange the paper for them. Back when there was a gold standard people became accustomed to accepting these pieces of paper for goods and services and I suppose that after that gold standard was removed that people still associated dollars with value. Even the government believes them to have value, after all they deliver mail for currency. It really is quite the phenomenon that we have made worthless pieces of paper valuable, but somehow it works.
The old income tax trick is another doozie by the government. It sets the points at which you enter a higher bracket but as money loses value people tend to make more of it and enter brackets that they wouldn’t otherwise be in and are required to pay higher percentages of income tax. This has been well documented and is just another trick up the government’s sleeve that most people do not recognize.
I think I am having trouble clearly explaining your question of, “So how does a market figure out how much the dollar is worth?” I would advise you read chapter 9 of Milton and Rose Friedman’s Free to Choose (http://www.amazon.com/Free-Choose-Statement-Milton-Friedman/dp/0156334607/ref=pd_bbs_sr_1?ie=UTF8&s=books&qid=1229619363&sr=8-1).
Your comment that if the government puts $500 billion into the system buy buys goods that were produced then the new money supply should be offset the production is a solid analysis but slightly flawed. The equation we are aiming for is for the growth rate in the money supply to roughly equal that of the GDP. The first problem with your analysis is that the $500 billion is representative of revenue, not income. GDP is more of a representation of income. Production, in the sense that I am using it, is strictly value added production, which is equitable with income and with GDP. As such, even though Boeing would bring in $500 billion in revenue, they would only bring in a fraction of that in actual income and only the income would really be considered in the GDP. For your reference, Boeing’s profit margins are typically about 5-6% of revenues. Therefore, the government is creating far more money than the nominal increase in GDP from the sale of helicopters. The second problem is that we are calculating growth rates, not simply nominal growth. The GDP for the United States is about $13 trillion and is actually shrinking, but M1 and M2 in the United States add up to being only around $7.9 trillion, up from about $7.4 trillion a year ago (hence the huge devaluation of our currency). I really want to point out though that you are absolutely on the right track with your thinking that production must meet money supply. Hopefully this will clarify the relationship a bit.
You kind of attack two different things in your paragraph about why Boeing would accept money from the government that was simply created out of thin air. First, there are a number of reasons that Boeing would happily accept the money: 1. they don’t know exactly where this money is coming from, the people paying Boeing don’t even necessarily know, 2. most people in Boeing and in the government probably do not understand the relationship of money supply and inflation well enough to call it a moral hazard to accept $500 billion, 3. greed, whether we like it or not, is part of human nature and isn’t going anywhere. There is little doubt that Boeing would rather take the government’s money even if they knew it would cause inflation. Whether you consider this a moral problem or not, we must attack the head of the snake if we are to beat the problem, and that head is the government creating the money. You then go into the idea that Boeing doesn’t have an ideal product and therefore going to lose business if they don’t take money from the government. This is getting into philosophical debate over whether or not something is ideal and exactly what ideal is. While this may be fun, it is beyond the scope of our discussion.
I completely agree with your sentiment that the Fed is not arbitrarily trying to cheat anyone by creating money. However, whether they are trying to or not, they are still cheating people. I agree with you that it is tough to precisely guess the growth rate of the GDP for any given year, but you could imagine that a computer constantly taking moving averages of GDP growth over time could do a pretty good job of it and likely a better job of managing the money supply than a group of seven men with their own opinions and politics. At the very least the computer would cost a lot less money and remove the threat of corruption.
I believe I already addressed your last paragraph somewhat by stating that really there is no value to any of our money. It is a scary thing to think about, but it works as long as the monetary authority is responsible with the money supply. Regardless, you are absolutely right in thinking that it is almost like walking on thin ice. I do, however, have a good degree of confidence in fiat money so long as it is properly managed. For examples of how not to manage fiat money look to Argentina, Bolivia, or really any idiotic South American leadership.
Thanks again for your comments.
I think I understand M1, but M2 is a little above my head, could you clarify these two a little further?
In a free market economy, you have said that no exchange takes place without a result that ends in mutual benefit for both parties involved. If Boeing benefits, and the government benefits, how is this not free trade? How far beyond the trade do you look to determine if the trade was good or not?
It seems that if there were a trade between two diabolical geniuses, one of which synthesizes horribly toxic nerve agents, and the other creates amazingly efficient means to deliver said agents, this wouldn’t be a bad thing. I know this sounds ridiculous, but you are saying that the intentions of the trade don’t matter, only the mutual benefit of both parties and the lack of government intervention. Banking on someone’s motivation to be selfish is very accurate, but to bank on a person to be motivated selfishly AND financially may be something in our dynamic human condition that the free market is limited in recognizing and controlling.
“What kind of society isn’t structured on greed? The problem of social organization is how to set up an arrangement under which greed will do the least harm; capitalism is that kind of a system.” -Milton Friedman. I like this quote; for me, it hits the ‘nail on the head.’
I think this is where I’m going with my questions. You said at the end of one of your blogz that ultimately, it’s the people’s responsibility to elect a government that is fit to govern (or something to that effect). If it’s the people’s responsibility to fix all of this by changing who they support, why are you denouncing a government which is doing exactly what it promised it would do?
Let me try to explain this in more depth of inflation, deflation, disinflation and devaluation.
Inflation is created when money is printed. It may be printed because government needs cash to pay for programs it has promised. The other way is government realizes the economy slows down. So they lower the interest rate encouraging people to borrow. Builder goes borrow(federal reserve printed) and builds a new home. When the money comes back they just loan it out again. Adding money to the system over time.
Now the builder is adding GDP to the system so inflation does not occur. But the dollar does not get stronger because it was created out of thin air. There is interest still being payed on it.
One more thing to remember about inflation. The money created out of thin air has an interest rate on it that has to be payed till it is payed back. The Federal Reserve is sucking money out of the American Currency till the loan is payed off. Actually taking away from the dollars worth causing inflation.
Money is constantly being added to stimulate the economy and government expenditures. The builder adds some GDP and the inflation is not as bad. Government paying bills is straight inflation. So today we have 75% of our GDP in debt. That is everything America owns is mortgaged to 75% of its value and deflating.
Now this money when it enters the economy can buy as much as money already in the system. After awhile the economy realizes their is only so much GNP and more money so it automatically adjusts the cost. That is why in 1913 a candy bar was a nickel and today it is worth $1.25. Pure inflation. I believe in America we will see that double in the next five to seven years. Discuss later why.
Imagine a home purchase in 1950 for $25 thousand and today it is worth 250 thousand. To my best calculation that house is actually only worth $110,00. The rest inflation.
Deflation.
Now government raises the interest rate to slow the economy down. People quit buying decreasing demand for products. Prices drop, because people have to sell. They take a loss on the home. If the money is really contracted prices really drop. Not only do many home owners loose wealth but banks loose wealth because of foreclosures. But loans are getting paid off, returning it to the Federal Reserve thereby getting rid of inflation by deflation.
Now homes or things of credit are cheaper by this deflation. So one can stimulate the economy again, because new investors or home owners are willing to buy at lower prices even with interest rates higher. Their wages have not changed one bit.
So the government put the printed money into the economy and you and I who own things of credit loose money when deflation hits and paying off the loan. In essence through this action you just paid for the governments expenditures of the Federal Reserve back door taxation method.
Devaluation of the currency: Money is raised or lower against another currency to encourage or discourage imports or exports. This is how one balances their countries trade and the worth of one country to another.
So what this does if the dollar is devalued against world currencies. It means America will find it costly to buy foreign electronics, oil, and etc. It will make it cheaper for foreign countries to buy American products, military and agriculture to eat.
It is like inflation on world products. Oil today will cost twice as much tomorrow after the devaluation. It just depends how devalued American currency would be.
Disinflation: This describes the situation of inflation and deflation going on at the same time.
Inflation will be rising the cost of all products, but because deflation is going on also driving down prices on items of credit. Therefore, will have things of non credit going up and things of credit going down(dominate force). We could see that in America this time.
Now let me explain what is going on now since you understand the terms.
We have an internal problem of inflation. I mentioned earlier it is debt of 75% of the GDP. Lots of created money. Why we are called a debtor nation.
We also have the internal problem that the government is broke. It has no cash and can only pay debt with printed money. America finds it hard to pay the interest only.
Then the external problem. Imports have been soaring. It was created by Kissinger signing with Saudi an agreement that entailed. America develops your oil fields and Saudi will only take American dollars for oil.
This opened the door for foreign countries to want to sell Americans imports so they could have greenbacks to purchase oil. America just turned their head away from imports balancing exports. This also sucked our industrial companies out of America.
End of 2007 America’s internal sub-prime loans showed up in other countries. One bank in Europe took a hit back then for 85 billion on those loans. So the IMF said, enough is enough, your corruption of not paying debts is over. Congress met last March to study this. I believe in the election period it was planned to claim a credit crunch. After all if you look at credit then. Interest rates were find and money flowing.
The USA had to shut down their economy because the world powers had already notified America that the dollar was getting devalued as they did not want the worthless inflated American money anymore.
This is neat how it works but dastardly. So when they claimed a credit crunch it brought spending by American people to an abrupt end. Ships of imports stopped almost immediately from no credit, they say. Other reasons I will fore go here. All this because Americans shortly will not be able to afford those products like in the past.
In order for the world to receive valued dollars instead of inflated currency to pay the debt off. We export hard material products. The American currency that was inflated now gains value through exports to them.
Now the stimulus package is holding things together so one President will handle this, Obama. Feel sorry for the guy in a way. So shortly after he is elected. I believe things will start moving fast.
More deflation which will also bring on unemployment higher. My guess is 2010 devaluation of the dollar will really kick in if not sooner.
All total Americans will be robbed of their wealth through deflation to pay for big government spending and easy credit. Devaluation will come for importing to much(causing things to cost much more).
If American’s had gold backed currency. Yes, we would not have advanced as fast as we did, but Americans would be worth more as individuals and a country. By passing deflation and devaluation of this magnitude.
I can not say for sure. But, Kissinger said the other day we should consider an One World Order. I reason with question, did he plan this?
Lot more can be said how this affects and intertwines all the entities.
Quote:”completely agree with your sentiment that the Fed is not arbitrarily trying to cheat anyone by creating money” -end-
I missed this the first time. Really, it is the Mother of all taxation schemes of governments and people who hold the Federal Reserve Strings. Why does government every election lower the interest rate? To make sure the economy is moving so they get re-elected? Maybe has something to do with it? Creation allows them to create programs they could not otherwise afford and get kickbacks (lobbyists).
The only thing is that many politicians believe they can go on like this forever robbing from the people. That is true. Because during depressions or deflation people seek socialism, giving these pundit politicians more control then they had before.
Rothschild said in 1912-give me control of the countries money and I will control the country. 1913 he bought the USA gold and banked the Federal Reserve with congress’s permission. Do you think he/they knew what was happening?
If one looks at the Judicial court system records. They will notice how all of sudden the courts took the state rights away and gave socialism to the Federal government to handle. Do you think congress or anyone knew what was going on? I think they know.
I think most in congress have Rothschild attitude.
Our forefathers warned of this and here is what Federal Chairman Paul Volcker had to say in 2000.
“Inflation is related to monetary policy. It’s related to the issue of money. The issue of money is a governmental responsibility predominately, and to use that authority in a way that leads to inflation is a system that fools a lot of people, and to keep fooling them you have to do it more and more, (that) is a moral issue. I myself in that camp.”
I think they full well know what they are doing is immoral. But then when you have an attitude of what is good for all (politicians decide) is most important. What do you expect?
That is why I constantly ask, “Who died and made you God?’ Government sure thinks they are just the cat’s meow.