Inflation

Inflation is the hot topic in current political and economic discussion. It is on the news, in just about every political address, been part of the last presidential election and certainly will be part of the upcoming race. What exactly inflation is is hard to answer when the talk comes from so many directions. The federal government and many news outlets have adjusted the everyday use of the word inflation so that it can fit into how they want it perceived rather than what it actually is. In reality it is very simple, widely simple really. Inflation is an increase in the money supply. That is it at its most fundamental level, nothing more and nothing less.

This distinction is so incredibly important for two main reasons. The first reason being that it is important to understand what inflation is so that it can be understood where it comes from, and ultimately how to properly address it. Secondly, in conjunction with the first reason, it breaks down all of the blatantly wrong arguments of what the inflationary problems are and how to fix them. Currently, the “fundamental” definition of inflation is often defined as an increase in prices. That is not it at all. But through that we have now been poisoned to believe that there are all of these spins off of inflation, each with their own issues and resolutions. We need The Fed to step in, government regulation, and an abandonment of the socio-economic system because of all the turmoil it has caused. Corporate inflation, cost inflation, built in inflation, open inflation, hyperinflation, government reported inflation, true inflation, the list goes on and on and on and with the current popularity of the topic every new station throws their spin on it to feed their narrative.

Again, inflation is simply the increase in the money supply. Looking at a simple economy, this can be broken down and understood very easily at its fundamental level. For giving credit where due, this is a spin off from Peter Schiff’s book, How an Economy Grows and Why it Crashes. Imagine a plane with 100 people in it flying over the ocean and an emergency crash landing finds said plane floating in the water next to a deserted island. All 100 passengers live, they safely make it to the island and they begin doing what a community would do. They each utilize their skills and capabilities to provide services for each other. One may be a cook, while one fishes. Another may make weapons for hunting while others babysit, and so on. At this moment they have no currency, they are just trading their skills and capabilities for the products or labors of other skills and capabilities. Eventually working out how many fish are worth how many hours of babysitting are worth how many pounds of meat are worth how much time spent cooking gets very complex and difficult to track. They come together as a community and decide it would be a lot easier if they had a measurable, consistent, and recognizable token that can be the universal trading tool for their island. They can price all the labors, resources, and goods back to this one unit of measure and trade that way. They just created a currency.

The community decides on a special stone that they had found in a cave nearby. It's limited, so it's not like anyone could just scoop up a pile of them. They’re unique yet still easily recognizable so they can’t easily be replicated or counterfeited. They’re limited, they've searched the entire island and there's no more caves or stones that match this particular stone in any way. For simplicity, say they found 5000 stones, so they divide out 50 to each person and start setting prices. Number of stones, scarcity of stones and goods/labor, opportunity cost, necessities vs wants/desires, and more. All of which work their way out through natural forces of trade that determine a community's day to day transactions. A fish is 2 stones, cooking is 1 stone per hour, a 6 pack of coconut milk is 3 stones, and so on. They adopt this currency and continue on living their lives on the island. One person sets aside some time and stones everyday for the resources necessary to build a raft. Once his raft is complete he announces that he's setting sail. He's going back to find his old life with television, air conditioning, fast food, politics, all of those modern life necessities we couldn't live without. He sets off and after a day of sailing comes across another deserted island. He decided to stop here for the night to rest and resupply. Upon investigating the island he finds a cave that has the same stones that are being used as money, but this time 95,000 of them. He packs them all up and immediately sets sail back to the island.

The next day he arrives at the island and yells for all the community to come see what he found. We have 100,000 stones now! We each have 1000 stones to spend, we're all rich! The island parties all night excited from their new riches. The next day they wake up and when the fisherman puts his fish out and sets the price at 2 stones again. But then someone else comes along, they have so many stones now, they offer to buy all the fish for 3 stones. They have the extra money, want to make sure they can get plenty, and don't want to fish themselves. Then someone else come by and offers 4, and then 5, and so on. There was an increase in the money supply on the island but because there was the same amount of stuff and people, the prices adjusted back to their relative value to each other, now with this greater supply of money. A fish is now 40 stones, cooking is now 20 stones per hour, a 6 pack of coconut milk is 60 stones, and so on. The real value of items they are trading amongst each other did not change, but the tool they used to measure the value did. Therefore the prices adjusted to reflect the change in the measuring tool, their currency. Rising prices are not inflation, an increase in the money supply is inflation. Rising prices are a symptom of the underlying cause, not the cause itself.

The government twists and manipulates the increases in costs and the definition of what inflation is to hide the true money printing they are responsible for. The Federal Government has built a dam through “marketing” of inflation, corrupt indicators, the accounting methods used to report how much debt there truly is to hold back this impending flood of inflation. At the surface to the untrained eye it all looks fine. When the economist, entrepreneurs, and investors truly go in and inspect what is going on, we can see it crumbling. The entire wall has been built on a weak foundation. There is no integrity, no planned structure, no real engineers worth their salt evaluating the true magnitude of what they are trying to hold back. They're just filling and covering cracks as they appear, layer after layer, without actually addressing the structural flaws that are allowing the cracks to form.

So really what is the problem? Using the example of the simple economy, there should be no frail and fractured dam holding back the impending financial flood. But that was a simple economy and a simple and unrealistic explanation of how money is created and distributed. The government does not just print money and hand it all out. They base their policy on flawed economic theory and when anything at all starts to crumble they blame capitalism (although true capitalism is by no means the economic system we use). Going back to the simple island economy example, and while this is still greatly oversimplifying the entire process, imagine the guy who found the new cave of stones had a magic stone creating machine.

He looked around the island and he said you know, I think we need to build a wall on the beach to keep the tide from destroying our docks. We also need some roads so we can get around faster and easier. We need a school so our kids can learn and become smarter. The people of the island were not necessarily opposed to some of these ideas but they didn't want to give up many, if any, of their stones to fund these ideas. So Econ John (we’ll give him a name now) says well how about this. I can magically make the stones needed to pay for all of this stuff. It will introduce more stones into the economy, when I do either things will get more expensive or we can consume less to lessen demand in the short term. A short reduction in consumption of resources to build these community needs will allow us to live at a higher standard once its all complete. Then once we have these communal needs, we can take the extra stones back out and we will all be better off and able to consume and spend like before we had all of this new stuff. The community agrees, the stones are made and used to pay for the creation of all of Econ John’s ideas. In the meantime, the prices of everything were never adjusted to reflect the increases in stones because the community followed Econ Johns advice.

Everything is built now and Econ John tells everyone, alright if you have any of those extra stones, I need them back please. While everyone has more stones from working to build the infrastructure, sell the supplies, and as they generally worked their way into the economy, no one has “the ones that were created”. Econ John tries telling them that this is not how the system was supposed to function. But everyone is so happy that they have so many stones and everything is still so cheap because the extra stones were never priced into the market. They have these nice paved roads, they send their kids off to school every day, they want to keep this going and certainly do not want to lose their new found wealth.They are increasing their consumption more than ever before now that they have all the new amenities as well as the stones they don't want to re-pay. So Politic Dick comes in and tells the community he has a great idea. He suggests that it worked so well, why don't they do it again. This time they can build parks to play in, and a military to protect them from sharks and whatever else could possibly be out there, and they pay people if a storm blows through and knocks over their coconut tree (because that's not their fault and is completely unforeseeable), finally Politic Dick will take just a few stones for himself for managing and keeping track of all of this. On top of that, if they agree to let him control the magic stone making machine, he will make enough stones to replace the ones they took out the first time.

The community kicks Econ John out of control of the magic stone machine and place Politic Dick in charge of it. This is, in very simple terms, how we have managed to get where we are as a country. The government has told us all this money printing is transitory, we're going to pay it back when we're better off. And that we will be so much better off we wont even feel the constraints of having to repay it. Do not price all this money into the market, it will cause unnecessary short term distress and panic. For years and years, administration after administration, this same old song and dance has played out. They've bought more and more voters over the years through promises of taking care of them and being the ultimate safety net and provider. Investors, true entrepreneurs, and foreign countries who have been buying our government bonds are coming to realize that this debt is not going to be paid off, its going to be monetized. It is going to be left in the economy and prices have not been adjusting to reflect it. Certainly there have been some price adjustments, but many of the best economists estimate inflation rates are, at minimum, double what the government claims.

The story told with Econ John and Politic Dick has some obvious disconnections from reality, but the underlying principle is the same and not as far off as you may think. The government pays their bills by generating bonds, or a promise to repay borrowed money. They are available on the public market to purchase, but because the rates of return are below the rate of inflation it makes no sense to buy them. So the Federal Reserve (no governing authority or legal connection to the Federal Government, it's just the name of the bank) steps in and writes the Federal Government a check. But the Federal Reserve has no money. They write the Federal Government a check with no backing that the Government has given them that privilege to write at 0% or near 0% interest since the 2008 housing crash. They literally write money out of nothing into thin air. The Government uses that to pay its bills, promising to repay, though not only are they not lowering their balance sheet or even keeping it even, but it's increasing more so every year than the previous year. At this point the Federal Government and Federal Reserve have painted themselves into a corner. If the Federal Government tried to truly sell bonds on the public market, they would have to pay upwards of 12+% interest to get buyers. But that would be admitting that real inflation is higher than they've been reporting. If the Federal Reserve stops loaning money at or near 0% then they would be admitting that the policy prescription they've adopted to “stimulate the economy” for the last near decade and a half was wrong. Unfortunately what that means for us is we have until the rest of the world gets tired of the US Dollar being the world's reserve currency. Then there will be a sovereign debt crisis that will make the 2008 housing crisis look like an amusement park.