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 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.
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!