Crash Course Chapter 11: Inflation

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We’ve got one more key concept to share before we go deeper into current economic conditions: Inflation.

Most of us think of inflation as rising prices, as if it were things becoming more expensive, but that’s not quite right.  It’s actually your money losing value.

Imagine if one year an apple and an orange are a dollar each, but next year they are ten dollars each.

Since you enjoy eating apples and oranges the same amount in one year as the next, then they will be exactly the same next year as this year.

But next year they will cost ten times as much, which means that the only thing that’s truly changed in this example 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 things we want to buy.

What we experience is things going up in price, but in fact inflation is really the value of our money going down, simply because there’s too much of it around.

Now, 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 just shot up in price ten-fold.  But 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.

Which puts us in the camp of Milton Friedman who claimed that inflation is everywhere and always a monetary phenomenon.

Again, inflation is not rising prices.  They are the symptom.  The cause of rising prices everywhere and always is an excess of money relative to the things people want to buy.

And what’s true within our tiny life raft example 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.

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. Zero. None.

That is, over a one hundred and eleven year period if you saved a dollar you had a dollar.  Put another timeline under this one, with 1903 on one end and 2014 on the other. To contrast this to today, if one hundred and eleven years ago you saved a dollar, today you would have about 2 cents.

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 the “Continental” 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 continentals were 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.

Seen on the inflation chart, the Revolutionary War took the general price level from a reading of “5” to a reading of “8” which is a pretty serious increase of some 60% in so short a time.

After the war, the paper continentals were utterly rejected by the populace, who strongly preferred gold and silver.  Most interestingly, with the return to using gold and silver as money, 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.    Just try to imagine a world where you will know the price of things hundreds of years into the future…because they will be the same as today.

At any rate, prices remained stable until – you guessed it – another  war came along – the civil war – which was highly inflationary.  Eventually, before too long prices again returned to their baseline levels.

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

And then war came along, 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 America 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 in preference.

And second instead of dismantling the war apparatus upon conclusion of hostilities the Pentagon was built, 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.

The reason is simply because the government spends more money than it has, so we can amend this statement to say that ”government deficit spending is inflationary.

We discussed the reason why back in the chapter on money and wealth where we noted that prices can only remain stable if there is a stable relationship between the amount of circulating currency and the things we need and want to buy.

When the government borrows money that is printed out of thin air by a compliant central bank, the new money definitely has real purchasing power.  But where did that come from?

By definition it is not possible to print up real things, only purchasing power so any and all acts of printing simply removes a tiny fraction of the value of all the other outstanding money and gives that real purchasing power to the new money.

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 where any physical restraint on human desires was removed from the system, 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 probably view it as level ground.

That is, you expect inflation and plan for it, as if it were an unavoidable feature of life like gravity.    But I hope we’ve shown you that sustained inflation wasn’t always a permanent condition of life but rather a recent development.

And the cause of that persistent inflation is simply that money and debt have been growing faster than the economy on a percentage basis for decades.

Which means your money has been 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 increasingly having to work harder and harder just to stay in place; and it means increasingly perplexing and astoundingly risky investment decisions have to be made in an attempt to grow ones savings fast enough to outpace the creation of money and debt.

It means two incomes are needed where one used to suffice, leaving less time for family & community strengthening  while both parents work.

A world of constantly eroding money is a devilishly complicated world to navigate and, for most, leaves scant room for error.

But – wait a minute – you’re thinking – inflation has not yet really gotten out of control yet and the Fed has been printing like crazy for a while, how can that be?

Actually we are experiencing a huge amount of inflation but we have to remember that inflation applies to anything that people might want to buy.

Sometimes inflation means the basic necessities of life like bread and gasoline become more expensive, and sometimes inflation means that our houses become more expensive to purchase, and sometimes, as is true today, it means things like stocks and bonds shoot up in price.

Quite unfairly, when governments print like crazy, those closest to the printing benefit the most because they have access to all that newly created money first.  The name for this is seignorage, and it has been known about for a long time.  It’s a very well understood process.

In today’s world, those closest to the money printing are already fabulously wealthy – you’ve heard about the 1% – and after a point, additional money in their hands does not stimulate as much in the way of additional purchasing of things like bread and gasoline…there’s only so much one can consume.

The wealth disparity in the US is now as large as it has ever been and that is largely just a known side-effect of central bank printing.

But the money these ultra-wealthy families and financial institutions have piles up faster and faster and it has to go somewhere, and so it does.  First into anything that can contain that much money, so it goes into the largest and most liquid markets, like US Treasury bonds and the stock market.

That’s stage one and it has already happened.

Then it goes into things rich people can most easily appreciate such as fine wine, high-end art, and trophy properties.

That’s stage two, and it has already happened.

Eventually, as paper investments begin to look shaky due growing concerns that there’s just too many claims on real wealth,  these concentrated holders of wealth will shift out of paper and back into real things.

Slowly at first, but then suddenly towards the end.

Real things like land, metals, housing, and basic commodities begin to rise in price as we shift to stage three of the inflationary process.

Looking at the exponential trajectory of our money supply since America went off the gold standard in 1971, and the increasingly extreme recent measures discussed in the chapter on Quantitative Easing, we are dangerously close to entering Stage Three if not already in its early days.

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.”

Now, finally, in this chapter of the Crash course we can string together these three important dots.

  • Number 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.
  • Number 2 –  At this same time, the money supply and debt levels turned the corner started piling up at  rates much faster than the economy was growing; and
  • Number 3 –  Inflation is the fully predictable outcome of facts #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 the video series.

All right, 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 actually a rather recent development.

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.  We might also observe that this policy benefits a very small group of individuals and institutions at the expense of literally everybody else.

Most unfairly, it robs from our future selves to satisfy our current cravings.

Okay, now that we’ve covered compounding, money, and inflation, you’re nearly fully-equipped with the tools to get the most from the remaining sections of The Crash Course.

But, there’s one more tool to put in our kit:  A better appreciation for really big numbers.

Please join me for the next chapter: How Much Is A Trillion?

Thank you for listening.

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