Crash Course Chapter 10: Inflation

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We’ve got one more Key Concept to share before we launch into current economic conditions, and it concerns inflation.

Most of us think of inflation as rising prices, but that’s not quite right. Imagine if an apple and an orange are a dollar each one year, but ten dollars each next year. Since you enjoy eating apples and oranges the same in one year as the next, then the only thing that’s truly changed here is your money, which has declined in value.

Inflation is not caused by rising prices. Rising prices are a symptom of inflation. Inflation is caused by the presence of too much money in relation to goods and services. What we experience are things going up in price, but in fact, inflation is really the value of your money going down simply because there’s too much of it around.

Here’s an example: Suppose you are on a life raft and somebody on board has an orange that they are willing to sell for money. Only one person in the raft has any money, and that’s a single dollar. So the orange sells for a dollar. But wait! Just before it sells you find a ten dollar bill in your pocket. Now how much do you suppose the orange sells for? That’s right, ten bucks. It’s still the same orange right? Nothing about the utility or desirability of the orange has changed from one minute to the next, only the amount of money kicking around in the boat. So we can make this claim: Inflation is, everywhere and always, a monetary phenomenon.

And what’s true within a tiny life raft is equally true across an entire nation. Here, let me illustrate this point using a long sweep of US history.

What we’re looking at here is a graph of price levels in the United States that begins on the left in 1665 and progresses more than 300 years to 2008 on the right. But at this moment, only inflation over the period from 1665 to 1776 is marked on the chart. On the “Y” axis, what is being charted are price levels, *not* the rate of inflation. Now, you might ask, “How can we compare prices in 1665 to prices in 1776, let alone 2008? Life was so different between those periods.” While there are some obvious liberties that have to be taken here, what is being compared are the basics of life. People ate food in 1665 as they did in 1776. People had to transport themselves, get educated, and live in houses in 1665 as they did in 1776. So what is being compared is relative cost of living in one period to the next. That is, inflation.

In 1665, the basic cost of living was set to a value of “5”. What is most striking about this chart to me is that from 1665 to 1776 there was absolutely no inflation. For 111 years, a dollar saved was, well, a dollar saved. Can you imagine what it would be like to live in a world where you could earn a thousand dollars, put it in a coffee can in the backyard, and your great- great grandchildren could dig it up and enjoy the same benefits from that thousand dollars as you would have 111 years previously?

This isn’t a fantasy in a cheap novella, this was reality in our country at one time. The country was on a silver and gold standard during this period and advanced tremendously while enjoying near-perfect price stability during times of peace. However, along came a war, the Revolutionary War, and the country found itself unable to pay for the war with the gold and silver to be found in the Treasury.

So a paper currency called “continentals” was printed, and at first it was fully backed by a specified amount of real gold and/or silver in the Treasury. But then the war proved to be more expensive than thought, and more and more was printed. Then the British, aware of the corrosive effects of inflation on a society, started counterfeiting and distributing vast amounts of bogus continentals, and soon the currency began to collapse.

Before long, massive inflation took hold, and Abigail Adams complained bitterly about this experience, noting that goods were hard to come by, making life difficult.

Seen on the inflation chart, the Revolutionary War took the general price level from a reading of “5” to a reading of “8”. After the war, the paper continentals were utterly rejected by the populace, who strongly preferred gold and silver. Most interestingly, price levels promptly returned back to their prewar levels.

The next serious bout of inflation was also associated with a war, again due to overprinting of paper currency, and again, upon conclusion of the war, we saw a relatively prompt return of prices to their pre-war levels, where they stayed for an additional 30 years. By now we are nearly 200 years into this chart, and we find that the cost of living is roughly that same as it was in 1665. That’s a truly fascinating concept to entertain.

But then a war came along – the Civil War – and it was a doozy. To finance the war, the North had to resort to printing a type of currency that still lends its name to our own currency today. Of course, back then it really did have a “green back.” Again we see a rapid rise of inflation as a direct consequence of war that again returned to baseline after the crisis was over. We are now 250 years into this story and the cost of living is still roughly the same as it was at the start. Can you imagine?

But then another war came along, this one even bigger than any before, and again it was a highly inflationary event.

And then another war, even bigger than any before it, which again proved inflationary. But this time, something odd happened. Inflation did not retreat before the next war began. Why? Two reasons. First, the country was no longer on a gold standard, but instead a fiat paper standard administered by the Federal Reserve, and the populace did not have another form of money to which it could turn. And second, because this was the first time that the war apparatus was not dismantled upon conclusion of hostilities.

Instead, full mobilization was maintained and a protracted cold war was fought; certainly as inflationary a conflict as any shooting war ever was.

And now if we look at the entire sweep of history, we can make an utterly obvious claim: All wars are inflationary. Period. No exceptions.

Why? Simple, really. Any time the government engages in deficit spending, it creates the conditions for inflation. However when the deficit spending is on legitimate infrastructure, such as roads or bridges, that investment will slowly “pay for itself” by boosting productivity and paving the way for the creation of additional goods and services that will ‘soak up’ the extra cash over time.

Wars, however, are special. Vast quantities of money are spent on things that are meant to be blown up. The money stays at home, while the goods get sent off to be blown up. When a bomb blows up, there is no residual benefit to the domestic economy later on. This means war spending is the most inflationary of all spending. It’s a double whammy – the money stays behind, working its evil magic, while the goods disappear. Heck, even if the goods aren’t blown up, there’s practically zero residual economic benefit to such specialized hardware, as amazing as that technology may be.

For some reason, the most recent pair of wars have been presented by the US mainstream press as being relatively “pain-free” for the average citizen, despite overwhelming historical odds to the contrary.

In fact, on this 15-year-long chart of commodity prices, we observe that prices bounced in a channel, marked by the green lines, for more than 10 years. However, and now hopefully unsurprisingly, shortly after the start of the Iraq War commodity prices began marching higher and have inflated nearly 140% in the five years since. Your gasoline and food bills will confirm this.

So if anybody tries to tell you that you haven’t sacrificed for the war, let them know you sacrificed a large portion of your savings and your paycheck to the effort, thank you very much.

At any rate, back to our main story. Here’s inflation between 1665 and 1975. Knowing what you now know about Nixon’s actions on August 15th 1971, what do you suppose the rest of the graph looks like between 1975 and today?

This is your world. You’ve been living on the steeply rising portion of the graph for so long that that you think it’s level ground.

Because inflation is now a permanent feature, and because it advances at a percentage rate, your money is declining in value exponentially.

That’s what this “hockey stick” graph is telling you.

What does it mean to live in a world where your money loses value exponentially? You know what it means, because you live there. It means always having to work harder and harder just to stay in place, and it means perplexing and astoundingly risky investment decisions have to be made in an attempt to grow ones savings fast enough to avoid the ravages of inflation.

It means two incomes are needed where one used to suffice, and kids left at home while both parents work. A world of constantly eroding money is a devilishly complicated world to navigate and leaves scant room for error, especially for those without the appropriate means or connections.

And it doesn’t have to be this way. And indeed, for the majority of our country’s history it wasn’t. And I’m hard pressed to say that inflation is a necessity and serves some essential and greater good, because a lot of progress and advancement happened between 1665 and 1940 without the “benefit” of perpetual inflation.

The point of this section was to help you appreciate the fact that our country has not always lived under a regime of perpetual inflation, and that, historically speaking, it’s a rather recent development.

To help put all of this in context, let’s mark the moments when our country abandoned the gold standard, first internally and then completely.

It may have surprised some of you, as it did me, to find out that inflation is not a mysterious law of nature, like gravity, but rather an extremely well-characterized matter of policy.

So now we have our fifth Key Concept: Inflation is, everywhere and always, a monetary phenomenon.

Flipped a bit, we can say that inflation is a deliberate act of policy.

Here’s what one wag had to say about this matter: “Paper money always returns to its intrinsic value – zero." Of course, he was a bit too pessimistic in his assessment, as this German woman proves by using her furnace to liberate the intrinsic heat content of paper money.

John Maynard Keynes, the father of the branch of economics that utterly dominates our lives, had this to say about inflation:

Lenin was certainly right, there is no more positive, or subtle or surer means of destroying the existing basis of society than to debauch the currency.

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of the citizens.

The process engages all of the hidden forces of economics on the side of destruction, and does it in a manner that not one man in a million can diagnose.

Given that the destructive, corrosive effects of inflation are so well understood by the architects and administrators of our monetary system, it’s fair to wonder exactly what the plan here is.

Now, finally, here in Chapter Ten of the Crash Course, we can string together these three important dots:

#1: In 1971, the US, and by extension the world, terminated the last connection to a gold restraint and federal borrowing “turned the corner,” never to look back.

#2: Concurrently, the money supply “turned the corner” and started piling up at a rate much faster than goods and services were growing.

And so we get to data point #3, which is that inflation is the fully predictable outcome of data points #1 and #2.

Boom. Boom. Boom. One, two, three. All connected, all saying the same thing, with profound implications for our future.

Now, if you’re of a mind that there’s no reason that all three of these graphs cannot just continue to exponentially accelerate to ever-higher amounts without end, then there’s no point in watching the rest of the Crash Course.

However, if you don’t happen to believe that, then you’re going to want to see the rest of this.

There is literally nothing more important for you to be doing right now than gaining an understanding of how these pieces fit together, assessing the risks for yourself, and taking actions to prepare for the possibility of a future that’s substantially different from today.

Now that we’ve covered compounding, money, and inflation, you have the tools to get the most from the remaining sections of the Crash Course.

We have a few more dots to connect. Let’s go.

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