Monday, January 12, 2009


This follows on from my comments on currency and deflation.

If the money supply shrinks, you have fewer dollars chasing goods. If it grows, you have more dollars chasing goods.


More dollars lead to increased prices and inflation, just as more bidders in an auction raises prices. Most people understand the basic idea that "stuff costs more." Okay, that's what inflation is, but rarely do I hear people talk about the cause and effects.

Examples of Inflation

If you doubt that more money causes inflation, look at the housing market. When lenders were giving loans to anyone, it flooded money into the real estate market. It should have surprised absolutely no one that there was a housing bubble. Lower rates and qualifications meant that it was less expensive to borrow (yep, money was actually cheaper).

In 2000, the rules for trading oil were relaxed (60 Minutes describes it as "effectively deregulated". And thus in July of 2008, a lot of money flooded into oil futures. Normal speculation (which tends to soften the spikes and drops of normal price responses) was overwhelmed by people new to the market, thus driving the price of oil far above what it would have been otherwise, and we're still trying to figure out what the price of oil is now.

Neither of those are examples of inflation per se, because properly inflation is a general increase in prices, not in just one area of the economy.

Effects of Inflation

So prices go up, so what? You know that when prices go up that it's harder to buy groceries, office supplies, etc.--your costs go up. So inflation hits people who are spending money. You trim your budget. Or you get a raise as your experience rises, hopefully faster than inflation. If you're a business owner, you know the phrase, "grow your business or die."

Another effect is that inflation hits people who have loaned money. Banks have loaned out money at (say) 6%. If inflation hits 6% it means banks aren't getting any return on their money. They're loaning out money and when it comes back, it has the same buying power. Which means that banks go out of business.

Ah, but what if you've borrowed money? You win on inflation. You borrow a dollar and when you pay it back, it's worth less than it was when you borrowed it.

So the big winner on inflation is anyone who owes money. And who's the biggest debtor in the United States? The US government of course. The same entity that can print money at will. Back in 1944 we promised not to do that at the Bretton Woods conference, but we seem to be ignoring that in our current effort to prevent deflation (see my last post).

And by the way, the US owes a lot of money. Current accumulated debt is about $10 trillion (that's $10 million million, or $10,000,000,000,000). The annual deficit has run about $300-$400 billion, but with all the bailout talk that is going to run to over $1 trillion, and Obama has promised that we've got billion-dollars of deficits for years to come.

All of that doesn't even include the expected $54 trillion we've promised in social security but haven't been funded.

Which is what I've been leading up to: what to do about all of this. I'll tackle that in my next post.

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