Mish's Global Economics Blog Discussion

Another excellent series:

THE AMERICAN INFLATION
Where we are, How we got here, and Where we are going
Part 1 of 3
by Jordan Roy-Byrne
Trendsman.com
July 5, 2007

DEFINITION OF INFLATION

Over the years, as United States policy makers have pursued an inflationary monetary policy, the definition and attention towards inflation has changed from the cause to the effect. Here is Webster’s definition in 1983:

"An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand.

Here is Houghton Mifflin’s definition in 2000:

A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.

Here is Wikipedia’s take:

In mainstream economics, the word “inflation” refers to a general rise in prices measured against a standard level of purchasing power. Previously the term was used to refer to an increase in the money supply, which is now referred to as expansionary monetary policy. Inflation is measured by comparing two sets of goods at two points in time, and computing the increase in cost not reflected by an increase in quality.

The cause of inflation has been relegated as secondary. The changing definition illustrates our changed perception of inflation. In the days of the gold standard, everyone knew inflation resulted from an increase in the supply of money. In today’s world, few know or understand the cause of inflation because society has been educated to believe that inflation itself is the effect, rising prices. As the great economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Now that we know the correct definition of inflation, we shall take a brief and general look at the monetary history of the United States.

US MONETARY HISTORY

Prior to the creation of the Federal Reserve in 1913, there were two national banks. The first bank existed from 1791 to 1811 at the behest of Alexander Hamilton, who opposed the views of Thomas Jefferson and James Madison. In 1811 Congress refused to extend the bank’s charter. The Second Bank of the US (1816-1836) a copy of the first, was brought down by President Andrew Jackson. Jackson vehemently opposed the idea of paper money and a national bank. While most would say that the Federal Reserve has given us faith in a central bank and paper money, we must remember that the idea of a central bank has been a contentious issue for most of our history. Thus, it would come as no surprise, historically speaking if contention over the Fed’s existence surfaced.

Turning to the money component of the monetary system, it was “hard currency” that played the large role until 1971. From 1785 to 1861 the country was on a silver standard. Following the Civil War, the country was on a gold standard from 1871 to 1971. Inflation only spiked during wars as the government essentially printed money to fund each and every war. After the wars, inflation (presumably because the paper was drained from the system) receded to pre-war levels. The country was on a strict hard money standard until it was first significantly altered by FDR during the Great Depression. He outlawed ownership of gold and baited citizens into turning in their gold. The government’s ownership of increased quantities of gold, allowed it to devalue the dollar by 66% and thus, institute the New Deal programs.

Following World War II, as per the Bretton Woods agreement, nations maintained a fixed price of their currency in terms of gold. This agreement fell apart when President Nixon took the US off the gold standard. He had little choice as foreigners were draining the country’s supply of gold, in exchange for their paper dollars.

While I support some kind of gold or silver standard, it must be noted that all was not well, all the time with the gold and silver standard. Runs on banks, financial panics and depressions were frequent occurrences. Small businessmen such as farmers struggled to advance themselves because under the gold standard they could not always get the credit they needed. Tight credit conditions also caused numerous banks to fail. Nevertheless, from a very long-term perspective, the country flourished and became a world power under the standard. The gold standard limited excess money creation, prevented fruitless growth in government and thus enabled primarily the free market and the private sector the opportunity to drive the country forward. Hence, in a little over a century, the US grew from 13 colonies into a world economic power.

Now take a look at these charts of the Consumer Price Index (CPI) and the M3 Money Supply:

Source: Michael W. Hodges, Grandfather Economic Report

(Hodges marks FDR’s dollar devaluation against gold as the elimination of the gold standard. It didn’t end officially until 1971 and at that point, you see prices soaring).

These charts, coupled with an understanding of our monetary history, illustrate beautifully our modern inflationary world and why and how this came to be. Since 1971, there has been excessive money and credit creation and prices have skyrocketed in a historical context. Without a gold or silver standard, there is no check on the amount of money or credit that can be created. Now lets take a look at the group that creates the money.

THE FEDERAL RESERVE SYSTEM

In the early 20^th century financial and economic leaders wanted a central bank for the role of lender of last resort. There were more than several bank runs and panics that occurred from 1890-1910. As a result, the Federal Reserve was established in 1913 with the mandate of fighting inflation and maintaining full employment. It attempts to achieve these objectives through managing interest rates via open market operations.

The truth is that the Federal Reserve, and central banks in general, are a form of Soviet style central planning. The Fed has control over the currency, its supply, and its value and therefore maintains great control over the economy. This means that there is no restriction (absent a gold standard) on its ability to inflate the money supply. Conversely, it can also contract the money supply, as it did by nearly 1/3 in 1929. Moreover, the Federal Reserve is a private, unaccountable, unelectable body that creates money out of thin air and loans it to the government and makes interest on it. It is shrouded in secrecy in that the public does not know the ownership structure of the member banks that own the Fed’s stock. The member banks derive profits from US taxpayers who foot the cost of the government borrowing from the Fed.

Why does the government borrow money from the Federal Reserve, when it has the constitutional authority to issue its own money, debt free? And why does the Fed have the authority to create money out of thin air and then charge interest on it? I’ll leave that to the “conspiracy theorists.”

What we do know is that since the advent of the Federal Reserve inflation has been a constant. Prior to the Fed, inflation over extended periods was nearly non-existent. Since the creation of the Fed, the dollar has lost 95% of its original value. It’s obvious that the Fed has failed on its inflation mandate. In terms of managing the overall economy and employment, the Fed has succeeded through continuous inflation (money creation). Though time will tell if the Fed can continue its inflationary ways without any visible and obvious adverse consequences. Now let’s take a look at the various inflation outlets.

MONEY AND CREDIT OUTLETS

There are several different outlets for new money and credit. Hence, inflation can manifest itself in various ways and forms. Monetary stimulus can make its way into the productive economy (capital goods and investment), or be used for consumption, or make its way into the various asset markets. Utilized effectively, monetary stimulus can have a positive impact on the overall economy. Unfortunately, the Federal Reserve maintains no control over the outlet of inflation. The Fed cannot control hedge funds borrowing money to speculate in the markets, it cannot control the extension of risky loans to speculators, it cannot control the federal governments wasteful expenses and it cannot force lenders to loan to only those making key capital investments. The hope is that money and credit growth yields greater growth in the production of tangible goods and services.

One can glean, from a look at our history, that since money and credit has become more widely available, the cumulative outlets have not been positive for the economy. According to Dr. Chris Martenson[1], the first trillion dollars was created from 1620 to 1974. It took 10 months to create the last trillion dollars. Do you think that the progress made in the past eight months is in anyway commensurate with that progress made from 1620 to 1974?

An abundance of available money and credit, as we have had for years, badly distorts usually reliable economic signals. This stimulus, rather than savings, earned income and gains from production, has fueled growing consumption, asset bubbles in stocks, bonds and property and in turn, the perception of a healthy and growing economy. Yet, most mainstream economists ignore these facts and automatically assume that asset bubbles reflect true economic strength. Credit is necessary to grow the economy but as I will explain in the next section, too much money and credit for too long severely exacerbates the foundations of an economy and ultimately the economy itself.

FIAT MONEY AND DEFICITS

Since 1971, when President Nixon abandoned the Gold Standard and effectively ended the Bretton Woods agreement, the United States and all other nations have possessed a currency that is fiat money. The dollar's value (and value of the other currencies) is derived from its acceptance as money by consumers and governments. Because it has no backing by anything tangible, the dollar, intrinsically is worth only the paper it’s printed on.

One can turn to 1971 and the desertion of our currency’s link to gold to examine how we have become extremely indebted and why deficits have been the norm. Here are graphs of the US trade balance as well as the US national debt, which accumulates from yearly budget deficits.

Both charts clearly show that 1) prior to the gold standard we rarely had trade deficits or debt problems and 2) since the abandonment of gold, growing budget and trade deficits have been the trend. The root cause of all this is a fiat currency. Without a gold standard, there is little incentive to have a balanced budget as the deficit money can be borrowed or printed out of thin air. Hence, the national debt has grown steadily since 1971. How a fiat currency has affected our trade deficit, is more complex.

A fiat currency has gradually increased the cost of living and the cost of doing business. Here are a few difficulties American producing businesses face. The expansion in the money supply has created a real estate bubble, which is a negative for businesses looking to setup shop here. That means higher rent on the property. Second, because of inflation, the cost of labor has risen. Third and on a macro scale, massive growth in government has occurred (inflation is a cause of this) thus causing more regulation of business. Essentially, a fiat currency, enabling inflation, has made it more difficult for American producers to compete with emerging nations. These emerging nations offer cheaper labor, favorable tax laws and less regulation because they are hungry for economic growth. Thus, American manufacturing and large service companies have either closed operations or moved them abroad.

Pundits state that the dollar needs to decline more for the trade gap to decrease. Since the dollar began its secular decline, the trade gap has actually grown larger. If the dollar falls another 30% will that suddenly boost our manufacturing sector and the products we export? How can that be the case when businesses have closed up shop and moved? The evidence is already there that the deficit is a problem of a larger magnitude that has little to do with short-term currency relationships. Seeking to solve the problem, some of our supposedly enlightened politicians are hungry for protectionist legislation to spur our exports. This of course would penalize our trading partners, (like China) who happen to hold most of our debt. And, as Peter Schiff recently wrote, “What (industry) is left to protect?”

The reality is that inflation has gradually made it far more difficult for the average American business to compete against the emerging economies of the world. The inflation of the past 35 years has gradually destroyed the real and the productive economy of America. A further fall in the dollar is not going to help our deficit. It will make the deficit worse as has happened in the past several years. After all, a falling dollar is a form of inflation. How can the supposed solution help when it's an actual cause of the problem?

TO BE CONTINUED WITH PART 2 OF 3...

Reference
[1] Dr. Chris Martenson, http://www.financialsense.com/fsu/editorials/martenson/2007/0108.html

© 2007 Jordan Roy-Byrne
Editorial Archive

CONTACT INFORMATION
Jordan Roy-Byrne
Trendsman.com
Seattle, WA USA
Email  |  Website