The most important financial question you must ask June 19, 2009
Posted by Jeff Nabers in Money.Tags: bernanke, bls, cpi, deflation, depression, ecnomy, fed, free market, freedom, geithner, government, greenspan, inflation, meltdown, monetary, Money, obama, paulson, prices, recession
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What is inflation?
I believe this is the most important financial question a person can ask. I am constantly on a trek to better understand money and wealth. Here is some of what I’ve learned thus far:
Per its original meaning:
- Inflation is not a rise in prices
- Inflation is a rise in the money supply
I have a 1920 Webster’s dictionary that says inflation is a rise in the money supply. I have a 2006 Webster’s dictionary that says inflation is a rise in consumer prices. From this point forward, I will use “inflation” for its original definition (an increase in the money supply) and I will use “price inflation” to refer to a general increase in prices.
How did this “Newspeak” happen?
Inflation is harmful because it leads to a rise in prices. When everyone’s expenses are rising faster than their incomes as a result of the actions of the government and banking system, it is like a tax on the American people.
With the harm being a rise in prices, the focus on the topic of “inflation” shifted from the cause (inflation) to the effect (rising prices). And so, over a period of decades, everyone (news media included) shifted into speaking about inflation as a rise in prices.
Why don’t inflation and price increases correlate directly anymore?
You can take simple economic examples and draw a direct correlation from increasing the money supply to a rise in prices not complemented by a rise in incomes. These are usually fictional stories of a group of people being stranded on an island and creating their own economy. They will illustrate with great clarity that increasing the money supply takes from the regular person and gives to the banker or his friends (such as the government).
Now apply those concepts to our current economy and you will be so confused, it will be easy to surrender to saying, “Gosh this stuff is for super-geeks to figure out and I’ll just go with whatever is reported to me.” Of course, we’ve learned that following the crowd and getting your information from normal reporting sources is a sure way to be led off the edge of a financial cliff.
Why do these simple concepts work in simple, theoretical economies and not our real economy? Why can’t we draw a direct correlation between inflation and price increases? We are on a trajectory away from a free market. Our country started with a 6 page Constitution. People and businesses were once operating in a free[er] market. We developed our understanding of the economy based on a free market. Today we have over 100,000 pages of laws and regulations. And each year we add to the pile. Almost every law interferes with the way things occur naturally. And almost every law takes us one step further away from a free market.
Our understanding about economics and money is based on the past, but we are in the present. In the case of inflation and price inflation, manipulations make the connection difficult to see. In a free market, inflation would create price inflation clearly and directly. But in our economy, the government has already tinkered with prices in countless areas. There are subsidies, tariffs, minimum price mandates, maximum price mandates, etc, etc. The buyers and sellers of the market don’t come together to determine price. They come together to try to transact within the confines of the 100,000 pages of laws and regulations that the government imposes. Within that system the price of one thing may skyrocket while other things stay the same.
What does monetary inflation do today?
In the case of the housing bubble, the Fed created tons of money through interest rate manipulation. In a free market that new money would have gone everywhere and prices of everything would rise. In our actual market, Fannie Mae and Freddie Mac (government-sponsored enterprises or GSEs) then attracted mortgage borrowers in ways that non-GSE private businesses couldn’t. That directed all of the new money into real estate and took its prices to the moon and then back down to earth. Now we all have whiplash and lighter pockets.
Meanwhile, the government organization that measures price inflation (BLS) has found that reporting price inflation (through CPI, the Consumer Price Index) is quite challenging. “Man, what do we do?! The prices of certain things are moving erratically!” thought BLS. They (and other governments) decided to make many adjustments to not count things rising rapidly in price. Through many phases of altering their calculations and adjustments, CPI charts have effectively become pieces of art with the economic utility of a Jackson Pollock piece.
The other day, somebody sent me a link to this chart and asked me what can be drawn from it. I replied that data was gathered, processed and reported differently from one decade to the next. It would be like taking the price of apples in the 50s, bananas in the 60s, oil in the 70s, cotton in the 80s, and wheat in the 90s. Now put that onto a chart. What does it mean? Nothing. Just like price inflation. CPI didn’t report the same thing 20 years ago as it does today, and putting the different reports on a chart and connecting dots with lines is almost as arbitrary as children’s connect-the-dot puzzles.
The difference is the child knows it’s a meaningless game. With our arbitrary line graph puzzles, we make big decisions based on them. Ouch.
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Jeff Nabers' Self Directed IRA & Solo 401(k) Blog 
I really like your down to Earth explanation about what inflation really is. Inflation is simply the recognition that the Federal Reserve Inc. has “printed money out of thin air”. The only people in the world who take advantage of newly printed money are the ones that receive it. Everybody else gets ripped off by the erosion of the purchasing power of every other dollar in cirulation.
You should also mention a few things to make things clearer:
– The Federal Reserve Inc. is *NOT* a government agency. It *IS* a private cartel of banks set up as a private corporation that has “stolen” the privilege of printing money. The Federal Reserve Inc. is unconstitutional as only Congress has this power (read the US constitution, it is clearly spelled out.)
– The Federal Reserve Inc. creates money out of nothing and lends it to the government at interest. Our taxes are then used to pay those interests.
– The fractional reserve system is inherently a scam that is the basis for today’s banking system. When a bank has $100 in deposit from Joe, it will create an extra $900 out of thin air to lend them to Jack, at interest. All money in the world today can be traced back to a debt to a bank. All the money in the world has no value. It is only debt issued by banks.
– Finally, you should talk about HR1207 (google it) which is a bill introduced by Ron Paul to audit the Fed Inc. The Fed Inc. created $2.1 Trillion (that is with a “T” $2,100,000,000,000) in September 2008 alone and gave it to its buddies. Nobody knows who got that brand new money nor what they did with it.
Are we BROKE yet?
PS- we are the biggest LIARS, Terrorist ,corrupt Nation on Earth,period end of story
ToTo- The 9000 banks in USA lend alot more than 10 to 1.
One particuliar bank which I’m aware does this,Loans a relative $10.1 million and next day the same amount is invested in the same bank as interest bearing.Now the bank claims it as capital.
You would be surprised to know that it is actual 1 to 300 loaned out.
If you want to start a bank,the policy is,you need to acquire $50 million as capital and you got 4 billions to loan–to anyone.
One sad part is that all these banks are Jewish controlled :^(
What is your point about “all these banks” being Jewish controlled? Where did you get that convuluted idea? Would it make a differance if all the banks were Catholic, Christian or Atheist controlled? Get to the truth…all banks are government controlled.
Well, looking at the fact that Goldman-Sachs is reporting a bumper year for bonuses, I would imagine quite a substantial amount of that 2T can be found in its coffers, don’t you think?
Inflation, from a classical definition is not merely an increase in the money supply, though you rightly point out this connection. But more importantly, inflation is an increase in the money supply in excess of productivity. You can increase the money supply without inflation as long as there is a correlative increase in the the production of tangible goods and infrastructure. An increase in infrastructure alone can decrease the cost of goods by lowering trasport and production costs. America’s – indeed the entire West’s problem, is that we have been increasing the money supply while allowing our infrastructure to crumble along with our productive capacity.
America formerly was at times able to increase the money supply while actually lowering the costs of goods. Today, America’s problem is that our money system, or, our monetary system is a rigged scam meant to reward a parasitical class of rentier/financiers, formerly known as an oligarchy. It is a fuedal system contrary to American principles of rewarding the productive class – both workers and entrepenuers. The recent, multi-trillion give-away to the banksters is indicative of how our system has devolved into one meant to turn the middle and lower classes into a herd of indebted cattle who are to be tax farmed into poverty. At the same time small business, especially those involved in the means of production, is to be saddled with unbearable debt. All the while the parasites are further enpowered and enriched.
America’s greatness was our once enlighted credit and tax system which rewarded creators, builders and producers, while utilizing the federal cedit system to also construct the most modern and far reaching infrastructure system the world had seen. Credit was directed towards these ends, with money not meant as a means in itself, but merely as a medium of exchange. Today the opposite is the case, the end result being credit, or money, used as a vehicle of enslavement through personal, business and governmnet debt. All the while our production and infrastructure crumbles.
Thus today, the money centered oligarchy is commited to destroying the last vestiges of America’s productinve and credit capacity, not caring if massive world-wide genocide is the result of the general breakdown of the worlds existing monetary system. Their only concern is that they sit upon the top when it ends, and that their absolute control of money and credit acheives that end.
America’s credit and productive capacity should once more be geared towards these ends. Your concept of a “Free Market”, is not, nor ever has been, the means by which nations assert sovereign control of the furtur for themselves and their posterity. It is through directing money/credit to acheive known ends that man plans his future. It is the minions and the mouthpieces of the masters behind the veil of the “magic of the marketplace” who, with their not so “invisible hands”, who, over the couse of the last fifty years have systematically destroyed the concepts of the soverign nation state that has the ability to control and determine its fate through the control of credit. As one of the deans of parasitical finance from the House of Rothchild once stated “I don’t care who rules a nation, I only care that I control its’ finance and money”.
Inflation is necessary for capitalism to work optimally. It creates the illusion of wage growth, and sometimes the illusion of profitability. It is a fiscal lubricant (and please bend over now). … While the Fed is routinely blamed for inflation, this is a little like blaming the sun for your sunburn. Only an idiot would blame the sun, and only an ignoramus would keep his life savings under a mattress. Because, in an inflationary credit system, saving is idiocy. Spending and/or investing is the rational response to a continuously devaluing (i.e., proliferating) fiat currency. Which, by the way, is a good thing. For if the growth of the money supply does not expand with population growth, generalized poverty is guaranteed. This is why the great populists of the last century, like William Jennings Bryan, argued against the “cross of gold.” Gold money favors the rich at the expense of everyone else for it allows them to protect, through scarcity, the intrinsic value of their fallow capital. The real enemy of the middle classes is Devaluation, which impairs the value of their assets far more than it enhances the value of their meager savings.
@Toto – Thanks for the extra points. I am in full support of HR 1207
@Eugene – You’re still talking about price inflation. The biggest problem with inflation and price inflation is that it can be so confusing that even bright minds can disagree about it. I agree that recently too much has been done to give incentives to the least productive, and of course those incentives are created by taking from the most productive. If this doesn’t reverse, we may see the most productive people and companies on earth leaving the U.S. eventually. It is certainly in our best interest to do whatever it takes to restore our country and retain its real assets–it’s productive and ingenious people.
@Ibeg – Your viewpoint is popular. Allow me to point out that money is a medium of exchange. It has absolutely no use in and of itself. It is used to make exchanges of resources (materials, labor, etc). The manipulation of the money supply doesn’t change the amount of resources in an economy or their relative value to the population. That said, how does a constant money supply in a growing population create poverty? It’s the same amount of resources. It would simply create price deflation. What’s wrong with price deflation? Would it be so bad if you woke up in the future and cars, homes, food, and everything else cost less? Is that really poverty?
Hmmm.Interesting.
Ibeg Todiffer, please dont try to confuse people. Inflation is a tax and is bad for people.
Deflation is good for people because it allows them to buy more for less
I am impressed with a lot of good points but one essential is missing. There is a definite tie to productivity….it offsets inflation to whatever degree. Yes, Fed target is 3% for the reason someone cited…it creates growth. The essential that is so far missing in the discussion is the VELOCITY of money. It is a key ingredient to how high (or low) the inflation rate goes. You can expand the money supply, but if money is not changing hands at an increasing rate, inflation won’t be increasing. We have a great history in Brazil that touches on every one of the points mentioned.
Deflation is a bad thing. A very bad thing. It actually reduces consumption, contrary to what many of you believe, idling capacity and halting investment along the way.
Jeff – interesting blog. Though it seems like it is written from a very political angle as opposed to an economic angle. Never-the-less, I think many people, particularly the younger generation, are ignorant of the dangers of inflation (and deflation as well). Up to today, there are no signs of price inflation resulting from the expansion of the money supply. In fact, many believe that the growth in money supply simply offset the deleveraging of the markets…balancing supply and demand in a new financial system of reduced leverage.
It might be simpler to think of inflation as a decrease in the value of the dollar.
A larger population would need a larger money supply; so to consider inflation as an increase in money supply seems limited to static population.
Inflation is a tax on savings; it is an incentive to spend or invest in hard assets.
Being a tax on saving, inflation helps keep the poor, poor.
Thanks for all the input! Allow me to respond, as I see that many of you are clinging on to ideas that are touted by those who didn’t see our recession coming and proved themselves a fool every step of the way. Open your mind as I share ideas that are touted by those who predicted the recession to a “T”.
@Don – How exactly does inflation create growth or productivity? It doesn’t change the amount of resources that money (merely a medium of exchange) can be traded for. In fact, anyone who isn’t a recipient of newly created money has lost a portion of their claim to resources.
@Matt – The idea that deflation is a bad thing is what made the Great Depression last so long. FDR believed that lowered prices actually CAUSED depressions. So he burned farmer’s crops and placed limits on how much they could grow in order to keep prices up. It was an expensive painful lesson and an obvious failure. The Great Depression only came to an end when the New Deal was abandoned and government spending was massively cut.
@Edward – Why would a larger population need a larger money supply? Money is a means; not an end. Changing the money supply can’t do anything to create wealth or productivity. To the contrary, it creates and worsens recessions and depressions by manipulating the price signals that tell businessmen what the market wants and by giving inaccurate signals of what projects are sustainable.
Returning to the true and original meaning of inflation is useful in order to understand the Austrian theory of the economic cycle which predicted the Great Depression and the 2008/2009 “Meltdown.”
Jeff: Thanks for your critique. I am pleased to learn my viewpoint is popular. News to me!
You’re right: money is only a medium of exchange. It doesn’t matter whether it’s paper, rocks or sea shells, its utility lies solely in its fungibility. Gold has no more intrinsic value than paper. Thought experiment: you are on a desert island with 11 other people and one coconut; try offering your Krugerrand for food and see it anyone is interested.
If the population grows but money supply remains static, the population must make do with less money per capita. The Law of Supply and Demand will make the money more valuable relative to what it can buy; i.e., prices will fall. At the same time, more people means fewer dollars per capita, so demand will fall; thus prices will sink further (including the one for gold). But that won’t help the poor or the newly mortgaged; the former lose their jobs and the latter see the value of their prime asset fall, perhaps below the value of their equity. No need to worry about resources; in deflation, they won’t be used because there is no money to fund the extraction/consumption cycle. During the Great Depression, crops were bulldozed to fight collapsing commodity prices even as people lined up for bread.
A little inflation benefits everyone. It is often said inflation is a tax, and in a sense it is. … It is a tax on the economic ignorance of the middle class. (There is no law that says you have to keep your savings in cash, to be inflated away by the Fed.) … It is not a tax on the poor, since they have no savings. And wage earners, whose livelihoods are tied to the real economy, are not hurt by inflation as their wages are delimited by productivity, not money supply.
Severe inflation is bad of course. But even a little deflation is a killer. Falling prices must lower profits, which eventually leads to layoffs, which reduce demand, and the vicious cycle once established is intractable.
I’m not defending the Fed here.
The gold standard is not in your interest unless you are a plutocrat who can only become substantially richer by impoverishing society at large. Our grandfathers addressed the problem in the ’30s (in part by dumping the gold standard) — but we forgot what they had to learn the hard way and required a new generation of crooks and hucksters to teach us all over again.
@Ibeg – The law of supply and demand is useful when applied to the actual goods and services being bought and sold. It has to do with how badly a person wants something and how much of that something is available. Again, the money is a mere method of exchange.
People having fewer dollars per capita just changes a ratio that was arbitrary to start with. The idea that inflation increases productivity or value or economic output is as silly as the idea that a stock split, in and of itself, does anything to change the value of a stock. A two-for-one stock split gives shareholders twice as many shares, each of which is half of the previous price, for a true change of zero. The difference with inflation is that the change in the money supply doesn’t give everyone extra money, it puts money into the hands of the government and whatever other recipients the Fed won’t disclose.
You say that in deflation resources won’t be used because there is no money to fund their purchase. That simply makes no sense. The only way there can be “no money” to fund transactions is if there is… well… no money. If the ratio of dollars-to-anything changes, it doesn’t make a transaction unable to be executed. Again, it just changes the arbitrary number of dollars that is being exchanged. When you take out the middleman dollar, it is still a matter of chickens being exchanged for wheat.
The concept of “a little inflation is good” brought our economy to its knees over the past few years. You see, price inflation can’t be centrally controlled. Nobody, no matter how intelligent or educated, can know the information (including desires and emotions) that is collectively known by the free market, as that information is stored in the thoughts and actions of its many participants.
Look at Japan; ridiculous amounts of monetary inflation couldn’t create price inflation. Look at the break up of the Soviet Union. The message is clear: Central economic planning has no history of success and an abundant history of embarrassing failures, our own economic blunder being the most recent case study.
It’s not that we can be sure the Fed or the government has bad intentions. It’s that central economic planning lacks the information needed to know what prices of every item should be at every given moment–especially the price of money, interest rates, which is a major mechanism for inflation.
Jeff: Alternatively, one could argue that a lack of investment prolonged the gread depression. But that’s neither here nor there as the current situation is enitrely different.
The fact is, our economy is based on growth. It must grow over the long run to remain a viable system. Growth requires an expansion of money – whether it be through an increase in the money multiplier (i.e. leverage) or through a physical increase in the money supply.
Now you say the “a little inflation is good” mentality brought our economy to its knees. Actually, a fear of inflation and decades of accelerating leverage brought our economy to its knees.
If your argument is that we need to watch out for skyrocketing price inflation in the future b/c of the increase in money supply, then I agree. But up to this point there are no signs yet.
Ibeg: I agree with you. Deflation is a killer.
@Matt,
1) One could argue anything. But the argument that a lack of investment prolonged the Great Depression doesn’t have a basis. First, understand that the government has nothing of its own to invest. It can only take from the people through direct taxation and indirect taxation (inflation, ala 1933 executive order 6102 during the GD). It can build roads and burn crops and do whatever it wants with its forcefully taken money, but it still doesn’t know what needs to be done. What needs to be done simply can’t be known in one central point.
2) I assume that by growth, you mean “productivity”. Your assertion that growth requires an expansion of money is broken upon an examination of history. There have been many deflationary booms. Again because price inflation (and price deflation) doesn’t affect productivity, it only affects an arbitrary ratio of dollars-to-things. Leverage still does not change the amount of resources available.
3) If what you say is true and a fear of price increases can bring an economy to its knees, then that economy is certainly not a sustainable one.
4) I think we do need to watch out for extreme price inflation. But more importantly we need to watch out for inflation, the cause of price inflation. The Federal Reserve is a central banking system (a third that followed two failed ones) that the founders of our country warned us against. Our highest law of the land, the Constitution, does not permit a private central bank or fiat currency. We are treading on dangerous ground when most laws are illegal themselves and most government actions are not authorized by the Constitution. History does not offer examples of oligarchy that allow for wide-spread prosperity.
Jeff: Thanks for trying to help me understand your point of view. But I’m still not sure I “get” you. Meantime, let’s quibble:
You wrote: “The idea that inflation increases productivity or value or economic output is as silly as the idea that a stock split, in and of itself, does anything to change the value of a stock…”
I didn’t say this, but contrarian that I am, I will defend it, sorta. Inflation supports business activity by increasing “apparent” profitability. If industry inflation is 3 percent, a stagnant business in that industry whose unit sales were unchanged that year may still show a 3 percent “rise” in sales and profit. So, its stock price may rise reflecting the sales and income data, and the higher valuation may help it invest in new capital equipment — voila, higher productivity thanks to price inflation. (In a similar manner, a stock split frequently increases a company’s market cap — which is why they do stock splits — since a lower priced stock is more easily bought.) Inflation may also improve your mood, which is good for the economy: a 10 percent COLA won’t raise your living standard if price inflation is 10 percent, but the bigger paycheck provides a psychological boost anyhow.
You wrote: “You say that in deflation resources won’t be used because there is no money to fund their purchase. That simply makes no sense.”
Maybe I should have my poetic license suspended. I didn’t mean literally no money and no resources — I figuratively meant less of each. Resources are not used unless there is demand for them. Demand requires the spending of money or it is unrequited. In the real world, commodity prices fall and commodity production falls, too, in a deflationary environment. If this doesn’t make sense to you, you need to check your paradigm.
Obviously, something “deflates” in a deflation and something inflates going the other way. You seem to be saying that money supply is irrelevant to price changes. Is that it? No one could disagree with you when you wrote “inflation [is] the cause of price inflation.” Some of us might suspect a tautology had been committed, though.
If price inflation is at 3 percent, a business will be paying 3 percent more for its expenses, so it will not translate directly into a 3 percent rise in profit. Additionally it has lost the buying power of its own holdings of dollars.
If a stock price rises due to false readings of true values, it is merely a setup for a future correction. Tricking businesses with illusions doesn’t change the underlying reality. Investing in capital equipment with deceptively received money is not an increase in productivity–it’s a misallocation of capital which will result in decreased productivity.
All of these false readings that you tout as benefits of inflation are truly the cause of the severity of our economic cycles. Yes, I will admit that inflation tricks people and businesses into wearing rose colored glasses. They go on to pat each other on the backs in congratulations of hollow accomplishments. But all that does is make businesses unable to see the actual amount of resources at their disposal and the actual demand for whatever they are selling.
Let’s turn our attention to another aspect of inflation. The recipient of new money isn’t only borrowers. Through “quantitative easing” and “monetizing the debt” the government is a major recipient of new money. We know that government does not do things productively or efficiently and it would be a mistake to ignore the huge decrease in productivity caused by allocating massive amounts of capital to the least productive major institution.
Jeff: This is basic economic theory. In a scenario of falling prices, consumers are incented to wait to make purchases because the same dollar they have today will buy more tomorrow. Therefore overall consumption falls leading to a shrinking of the economy, decrease in investment, layoffs, etc.
In a scenario of flat to slightly increasing prices, consumers lose this incentive to hold off on purchases as their dollar will buy more today than it will tomorrow. Thus consumer spending increases and the economy expands.
Moral of the story – slight inflation good. Deflation BAD.
Jeff: As for your 1) above, sorry I meant private investment. Not Gov’t investment.
PS – I have Milton Friedman on my side:
http://www.investopedia.com/terms/k/k-percent-rule.asp
Matt,
Consumption is not the key to any economy. Although it may be a key component to the crashing and burning of our economy.
Consumption can only come from production. They are two sides of the same coin. Over the long term, you can’t consume in excess of your production.
You are right; what you’ve said is a basic economic theory, but it is not the basic economic theory. It also happens to be the theory asserted mostly by those who are incapable of predicting economic events such as the Great Depression and our current economic woes.
On the other end of the spectrum is Austrian economic theory. Where other theories fail, Austrian theory does not. You should certainly check out http://www.mises.org.
Jeff:
Regarding your third paragraph, your argument is equivalent to: “People that believe in evolution were unable to predict our current financial problems. Therefore evolution must be wrong.” The validity of the theory I stated is in no way compromised because believers in said theory were unable to predict a severe economic downturn caused by a housing bubble, overleveraging, and financial engineering on wall street.
I will check out the website when I get a chance. I’m always up for expanding my knowledge in the area.
Another important benefit of inflation is that it cheapens debt. This is the economic equivalent of absolution for one’s sins. It is why current deficit spending need not burden our grandchildren, who will be able to make the payments on our debt with their chump change.
Jeff, you write of “false values” but there is no reference point somewhere by which “true values” may be determined. If there were, stock market activity would graph as a flat-line (or perhaps a square wave) since no “price discovery” would be necessary.
@Matt – I contend that economic theories are disproven when actual events happen that are contrary to the theory… especially when other theories exist that are substantiated by actual events over and over again.
@Ibeg – Cheapening debt encourages borrowing. Look what happens when borrowing is artificially encouraged. I wouldn’t consider destroying the economy to be a benefit of inflation.
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