On Inflation
A layman's guide to understanding money supply.
Inflation is a term used every day in financial media. This article will change your perception of this word. Most individuals who follow financial news hear or see the term daily, yet the discussion always revolves around what governments call Consumer Price Inflation (CPI). But what exactly is inflation, why is it happening and what are the consequences?
Herewith a screenshot from a popular financial author, describing what the term inflation means:
This is the standard explanation used by economists and journalists throughout the world to describe this phenomenon, and probably similar to your idea of what inflation is. But why are prices rising?
“When, in the 16th century, American resources of gold and silver were discovered and exploited, enormous quantities of the precious metals were transported to Europe. The result of this increase in the quantity of money was a general tendency toward an upward movement of prices in Europe. In the same way, today, when a government increases the quantity of paper money, the result is that the purchasing power of the monetary unit begins to drop, and so prices rise. This is called inflation.” — Ludwig von Mises
Inflation is not the rise in prices, it is the increase in the money supply! When the total amount of goods in an economy stays the same, but the amount of money increases, the amount of goods that can be purchased per unit of money decreases. Just reading this last two sentences without any financial background, you might think “That does not sound like something good” and guess what? You are entirely correct.
Why do we keep hearing that some inflation is good, but just not too much, then it becomes bad? Governments are always targeting a “healthy” inflation rate. Say this 5 times out loud:
There is no such thing as a healthy inflation rate.
Money is not a usable good that fulfils any human need on its own. It is simply a means of exchange. To increase prosperity in an given economy, one needs to increase the amount of usable goods and services. Increasing the amount of currency in an economy does not magically create more goods for the population to consume. If it were possible to create wealth and prosperity by increasing the money supply, and banks and government have the capability to create as much money as they please, why is it that there still exists poverty in this world? Because here is the kicker: IT IS NOT POSSIBLE TO CREATE WEALTH BY INCREASING THE MONEY SUPPLY, no matter what your college economics lecturer or local financial journalist has been telling you. The fallacy of wealth creation by means of monetary expansion has been logically disproven by many academics over time and has been disproven in practise over the last century.
Ok, so if inflation does not make us as a society better off, why does it exist and how is it created?
Im going to keep this very short, for a detailed explanation of what money is, this free book is great.
For the last 2000 years up until around 1900, gold was the world’s most widely used currency. For an explanation why, see this video or this book. Gold’s only weaknesses is/was its divisibility(its hard to make a gold coin small enough to buy a bread with), and is saleability across space(its difficult and expensive to move gold around and pay people not close to you, like in a different city or country). The solution: Banks. Banks take your gold(and holds it in reserve) and hands you a receipt or a note that is a promise to pay back your gold when you present the receipt. This solves both the before mentioned problems. Banks can denominate the receipts or notes in any amount, big or small, and you can deposit your gold at a bank in one city and ask them to pay someone in another city or country. Yay! But who is to keep the banks from just issuing more receipts than they have gold in reserves? The government right? There should surely be laws that stop them from doing this, right? Wrong.
Banks are allowed to create more receipts than the amount of deposits they hold, thus creating money out of thin air. In practice this is exactly the same as printing cash money with a money printer. Let me explain.
Barney has deposited $10 000 worth of gold with Goliath National Bank(GNB) and GNB has given him $10 000 worth of crispy new bank notes, redeemable for gold upon request. This is called 100% reserve banking(The bank holds 100% of the amount of notes issued in reserve). If all the GNB banknotes in existence are brought back and redeemed for gold, the bank would have enough gold to pay out.
Total amount of currency in existence at this stage: $10 000.
Now Ted wants to buy a new car, he applies to GNB for a loan of $5000. GNB prints more bank notes worth $5000 and lends it to Ted and Ted buys the car from a dealership. (They printed these notes the same way they printed Barney’s notes, but instead of giving them gold, Ted gives GNB a promise to pay them back the notes, plus interest).
Total amount of currency in existence at this stage: $15 000. (Barney still has his $10 000 and the dealership has $5000, GNB still only has $10 000 worth of gold in its vaults.)
Thus there has been 50% inflation, created out of thin air by GNB.
Total value of GNB notes in circulation: $15 000. Total amount of gold held by GNB in reserve $10 000.
10 000 / 15 000 = 10/15
The fraction of the total money supply held in reserve by GNB is 10/15 or 0.666%, this is called Fractional Reserve Banking.(Current fractional reserve requirements range from 0.03% to 0.1%)
But what happens when the car dealership and Barney both go back to the bank with their notes, claiming $15 000 in total worth of gold, when we all know that GNB only has $10 000 worth of gold in their vaults? This is what is called a “bank run” and has happened thousands of times in world history and this is why countries “need” reserve banks like the Federal Reserve in the US. “A lender of last resort”, the Fed and reserve banks can lend to a bank such as GNB that is about to go bankrupt because they are unable to fulfil their obligations. Yes, instead of outlawing or banning this practise, governments choose to add fuel to the fire by effectively telling banks: “Print as much as you want, lend out, go crazy. When the shit inevitably hits the fan, we will just bail you out without any consequences.” Governments do this because they themselves are the biggest lenders. More about this in Part 2.
The effects this has on society are so widespread that it is impossible to even comprehend, but let me name a few of the bigger ones.
Inequality.
Governments decide who gets a banking licence and banks decide who gets loans. Continuing from the example used above, when GNB loans the money to Ted, Ted has it in his possession but has not spent it yet. At that stage the 50% inflation has not fully occurred. It is only once the “new” money comes into circulation in the economy that it is used to bid up the prices of goods. Thus Ted gets to spend the $5000 at the price level maintained before the price hike caused by the monetary inflation takes place. In practise it can take months or years for the general price level to rise accordingly, but rise it will.
Let’s say Ted buys the car, the dealership pays the car manufacturer who in turn pays the steel mill, they pay the iron ore mine who is employing Steve. As the newly injected money ripples out through the economy, prices start inflating. Steve has worked hard in the mine and now also wants to buy a car, but because the market for cars has been artificially inflated by banks loaning money to Teds, he now has to pay $7500 for a new car while just last year Ted paid $5000.
The new money in the economy does not benefit everyone equally. The closer you are to the money printer(the easier it is for you to obtain finance), the richer you become. This is because you are able to purchase real assets with fake money BEFORE the assets artificially increase in value, thus making you richer and everyone unable to obtain finance poorer. The more fractional reserve money banks create and loan to their clients and partners, the richer they all become at the expense of the rest of the population. This forms a self fulfilling loop where the rich become richer and richer and the poor become poorer and poorer. And yet again, the kicker: You cannot obtain finance without having an asset as security for a loan and you cannot obtain an asset because prices are already so inflated that it’s impossible to afford without finance. This is called the Cantillon effect and was first described by Richard Cantillon in 1730. This is also the reason no one in the Western world under the age of 40 can afford to own property.
Forcing people to take unnecessary financial risks.
When a person has done a month of hard work and receives a pay check, she should be able to save the product of her labor for the future if she so desires. No one would agree that it is a good idea to spend your pay check the moment the funds hit your bank account. Because the purchasing power of our savings is decreasing by +-5% per year compounded, people are desperate to merely find a place where they can store some wealth. This is not normal. For 1 900 years out of the last 2 000 years, the majority of humankind had the option to store wealth merely by holding on to the currency they were paid in. Today we are forced to invest our savings in risk bearing instruments or face a massive depreciation in our wealth. It is almost impossible to comprehend the impact this phenomenon has on your life and society. Risky investments that would never have been financed in a hard money system burn through vast amounts of capital that could have been used diligently or saved, archaistic zombie companies that should have been left to die years ago keeps being propped up with cheap easy money. People spend their earnings on unnecessary shit they don’t even need or use. People often lose their savings to scammers or other nefarious actors because they are forced to invest their savings somewhere. This all because holding onto cash is like holding a hot potato.
This has been Part 1 of a multi part series I am writing on inflation. Part 2 will discuss CPI, what it is and what it’s not. Please follow me on Twitter or here on Medium to be notified when new content is released.
