Thoughts, essays, and writings on Liberty. Written by the heirs of Patrick Henry.

May 27, 2009

The Signs of Inflation

by tarran

Since Barack Obama has decided to continue down the path George Bush started down,  the path of Robert Mugabe and Friedrich Ebert, the United States economy will soon be facing all the problems associated with inflation.

Unfortunately, the effects of inflation are poorly popularized, meaning that most people have a very limited understanding of inflation.  As a result when confronted with symptoms of inflation people all to often pin the blame on other “causes” such as Jews or greedy white landowners.  These false accusations are heavily promoted by the ruling classes;  after all it’s better that the mob chase some Jews or hedge fund managers with pitch-forks than coming after the rulers who inflated the currency.

What Inflation Isn’t

The primary misconception of inflation is that it merely is the rise in prices.  The news media encourages people to believe this, reporting the inflation rate in the same way it reports on changes in the weather, as if it is some natural phenomenon over which people have no control.

Price increases are a result of inflation, yes.  However, inflation has the same relationship with price increases that war has with the number of burials per month at Arlington Cemetery.

The Mechanics of Inflation

Inflation is the phenomenon where additional money is created.  In the case of the Unites States, the Federal Reserve purchases some asset, such as a United States Treasury Bond, paying by check.  The seller deposits the check in a bank, which then records the additional money as part of its demand deposits.  This is the moment where the inflation occurs.  The bank then loans out 80% of those deposits to borrowers. Those borrowers spend the loaned money. This spent money is deposited back into the banking system. The banks loan out another 80% of this latest round of deposits. This cycle of loaning out money which then spent and then deposited back into the banking systems continues until eventually an equilibrium is established where banks list $4.00 in outstanding loans for every dollar created when the Federal Reserve Bank wrote that first check.

The Math:

A mathematical calculation of the growth of the money supply when central banks create money out of thin air.

A mathematical analysis of the growth of the money supply when central banks create money out of thin air.

The people spending this newly created money bid up prices;  people selling stuff tend to sell stuff to the highest bidder, and the people holding the newly printed money are competing with other buyers to purchase the stuff they want.

The result is that this new money slowly disperses out through the economy, leaving higher prices in its wake.  The people who spend it first get the benefit of being able to buy stuff at pre-inflation prices, the people who spend it last do not.  The people who have access to the newly printed money are left better off, the people who don’t are left poorer.  Inflation invisibly and without much fuss transfers purchasing power from those who are not closely connected economically with the central bank to those who are.

Follow the Money

The price increases generally show themselves in the sectors of the economy where the new money is spent.  For example,  let’s say that President Obama directs the Secretary of the Treasury to sell a bond to generate the money needed to build yet another bridge over some stream in West Virginia named after Robert Byrd. The bond is purchased by the Federal Reserve Bank with newly printed money.  The money is spent by the Federal Government on tools and materials needed to build the bridge.  The price for cranes, hourly employment of road-crews, concrete and steel increases.

The Rise of the Ersatz Product

The other users of these raw materials find themselves struggling to buy the  supplies they need.  For example, a manufacturer of prefabricated steel sheds might find that he has to pay more to get the metal he needs.  He is caught in a squeeze; the price his customers are willing to pay has remained unchanged while his production costs have increased. The manufacturer can’t raise his prices, so naturally he decides to cut costs by attempting to reduce the amount of steel he uses by substitution or adulteration.  The end result, the steel shed might cost the same, but the quality of the steel, the strength of the steel, or its toughness will be inferior, resulting in a shoddier product.  Candy bars are packaged to look like their sizes are constant, while the volume of candy is reduced.  Houses are built less sturdily.  Automobiles are manufactured with lower quality steel, with engines that wear out more rapidly, etc.

The Rise in Prices

As the money percolates out through the economy, the people coming into possession of it bid up prices.  In fits and starts, at different rates in different sectors of the economy, the price levels go up.  People on a fixed income find themselves becoming poorer and poorer.  The unpredictability of  the price levels causes  accounting to become more uncertain.  Investments and projects that otherwise would be attempted are foregone.  A majority of the population is left poorer as a result of the inflation.

Increased Political Repression

These people naturally lobby for relief.  However the political classes that benefit from the inflation don’t want to stop,  and the people are too ignorant of economics to recognize the fact that it was the printing presses which caused their problems.  Instead the people attack profiteers or greedy manufacturers or the greedy bankers.  They call for price and wage controls, which if instituted, further wreck the economy.

People also try to abandon the unreliable monetary system for alternatives.  They try to do business in foreign currencies or even use commodities such as cigarettes or gold chains as money.  Governments typically react savagely, criminalizing attempts to do business using alternatives to the rapidly devaluing currency.

Stop Me Before I Inflate Again!

Typically, when a government or central bank engages in inflation, they find it hard to stop – the political incentives are too great to resist. They cannot fund their operations if they stop the printing presses. The more the economy falters, the more the tax-base is disrupted, the lower the productivity of the industrial base, the more dependent the elites are on the printing press to fund their lifestyles and the operations of the state.  In private, the central-bankers will admit that the currency debasement is wrecking the economy.  But the central-bankers’ fear of the negative personal consequences if they should stop inflating the currency overrides any impulse to do the right thing.

America’s Peculiar Institution

Some economists argue that since the Federal Reserve is not part of the U.S. government such a doomsday scenario cannot play out here.  They claim that the Federal Reserve, being independent, is immune to political pressure.  Yet throughout its existence it has acted to support the U.S. government; periodically, the Congress threatens to update or revise the Federal Reserve Act to mandate greater congressional oversight of the Fed’s operations and the ‘independent’ organization suddenly becomes quite accommodating.

Historically, the Federal Reserve has purchased only a small fraction of the bonds issued by the U.S. Treasury;  it didn’t have to – there were always sufficient buyers willing to buy Treasury Bonds to keep the U.S. government operating.  That is changing.  The U.S. government will have to borrow more than a trillion dollars a year to fund its operations.  At the same time the U.S. Government is borrowing at such unprecedented levels, the willingness of voluntary investors to purchase the bonds is collapsing.  If the Federal Reserve were passive, within a year or so we would see U.S. Treasury Bonds routinely going unsold at auctions. The Federal Reserve, inevitably, will begin purchasing those bonds to keep the U.S. government solvent.

Protecting Yourself

In an inflationary economic regime, the formal economy is generally a suckers game.  To avoid being taken to the cleaners, consider doing the following:

  • Start or purchase a business making something in relatively widespread demand that is not likely to have price controls slapped on it.
  • Go into a profession where your skills will be in wide demand.
  • Learn how to fix broken things.
  • Cultivate circle of associates with whom you can engage in gray-market or black-market business deals.
  • Befriend a policeman or a judge! They can get you out of hot water should you get tagged for committing an economic ‘crime’.
  • Get to know local gold-dealers, particularly ones who buy and sell gold chains.
  • Learn how to defend yourself; police take time to respond, and are prone to prosecuting economic crimes when confronted by evidence of contraband.
  • Buy an old “Whip Inflation Now” button. It will be about as helpful as it was in the 1970’s

You don’t have to be helpless as the Democratic and Republican Party Apparatchiks loot the economy.  Prudent steps taken now can pay off in the coming dark years.

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  • John222

    Excellent post tarran. My thoughts exactly. Unfortunately, most people I try to explain this to seem to tune out at the word inflation. One of the biggest steps we could take toward liberty would be allowing ourselves to use real money.

  • Akston

    This is one of your best from my perspective, tarran. Your post explains in approachable English the logical progression of inflation through the economy. I’ll be sending a link to this post to quite a few friends.

  • http://hathor-sekhmet.blogspot.com VRB

    Would you cite the equation?

  • http://www.thelibertypapers.org/author/tarran/ tarran

    The equation is my own work; although I am sure it appears in textbooks on monetary policy; it’s a fairly basic series describing banks loaning out deposits while meeting their reserve requirements.

  • Nick M.

    any way tarran could you start attaching .pdf’s of posts. Maybe for just a week or so after you post. Most of your posts are quite long and, at least to me, don’t work real well on-screen.

  • http://www.thelibertypapers.org/author/tarran/ tarran

    Nick, I’l see what I can do.

  • southernjames

    The first two recommendations are good ones – but they are pretty tough, if you’re no longer in your 20’s or 30’s AND have been stuck in one career/job forever, and you need the paycheck to keep going….

    I would add – get familiar with, and comfortable with, dealing in a ‘barter’ system for goods and services. But perhaps that is what you mean by your fourth bullet point.

    Question: Why gold chains instead of gold (or silver?) coins?

  • http://www.thelibertypapers.org/author/tarran/ tarran

    Gold chains came into wide use as a form of money during the Argentine economic crisis.

    The advantages of gold chains:

    • The gold is valuable in and of itself.
    • There is a larger demand for gold jewelry than gold coins.
    • The chains can be trimmed down or cut into sections to make change or otherwise divide one’s wealth.
    • There is no way that the government will outlaw the ownership of goldchains. In the Great Depression, the government did outlaw the possession of gold coins.
  • Doug

    Krugman may be right in the near term on inflation due to the severe economic downturn but in the long run monetizing the debt could lead to hyperinflation. I’ve found more info on the weekly Mountain Vision e-mail letter, from Zurich, Switzerland.

    For a free subscription, just e-mail: contact@bfi-consulting.com and request the letter and provide your name & mailing address to avoid duplications. This an excellent way to keep up with the experienced, Swiss “big picture” worldview on global politics, government debt, the financial crisis, Austrian economics, investment markets, gold, the dollar, FED policy & other geo-strategic concerns and objectives. Perfect for investors desiring education on the importance of international diversification outside the US dollar in search of secure, legally compliant strategies to protect and grow wealth.

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