-- Posted Tuesday, 21 March 2006 | Digg This Article
The definition
The correct definition of inflation is an increase in the supply of money that CAUSES a decrease in the purchasing power of money, but we usually define it as simply an increase in the supply of money. This is done, in part, for the practical reason that it's impossible to measure changes in the purchasing power of money on an economy-wide basis.
It is not possible to measure changes in the overall purchasing power of money because it is not possible to come up with a meaningful number that represents the average price level within an economy. There are, of course, price indices such as the CPI that purportedly represent the average price level, but these indices are generally worse than useless because they are calculated in such a way that they are guaranteed to paint a misleading picture. And in any case, even an honest attempt to determine the average price level would fail. The reason is that even if it were somehow possible to determine a meaningful number that represented the average of things as different as eggs and new cars, a calculation that was valid today would, in a dynamic economy, be obsolete tomorrow.
To illustrate just one of the insurmountable challenges of coming up with a price index that accurately represents the EFFECTS of inflation let's consider the hypothetical example of the $2 widget made in the US. In our example we'll assume that monetary inflation within the US over many years pushes up manufacturing costs such that these widgets can no longer be made in the US and sold at a profit for anything less than $3; in other words, if nothing else changes then the inflation will cause the dollar's purchasing power to fall from 0.5 widgets (2 dollars = 1 widget) to 0.33 widgets (3 dollars = 1 widget). But something else does change. Instead of raising the selling price of the widget from $2 to $3 in response to the increase in costs, what actually happens is that our hypothetical widget manufacturer keeps the selling price the same and opens a factory in a part of the world where manufacturing costs are much lower. Therefore, in our example inflation causes the dollar's purchasing power to fall and this, in turn, leads to the closure of a factory in the US and an increase in the quantity of imported goods. Inflation has obviously had an important effect, but it's unlikely that any price index will capture this effect.
The other reason we use a simplified definition of inflation is that doing so does not, as far as we can tell, detract from our analysis. This is because persistent increases in the supply of money of more than a few percent per year ALWAYS cause prices to rise somewhere in the economy.
Inflation is a constant With the exception of the early-1930s the US has experienced inflation, and nothing but inflation, since the establishment of the Federal Reserve in 1913. Furthermore, after experiencing a few years of deflation during the 1930s -- deflation that was caused by Fed-sponsored credit expansion during the 1920s and NOT by the fact that the gold standard of the day was too inflexible -- changes were made to the US monetary system that greatly reduced the possibility of deflation occurring in the future. Specifically, it was made illegal for US citizens to own gold (1), which meant that falling confidence in the monetary/banking system could no longer lead to the banks' gold reserves being drained away (the potential for a run on dollar-denominated bank reserves was not a major concern because the Fed could always create more dollar reserves, but it couldn't create more gold). Removing the ability of citizens to legally opt for gold also paved the way for a government-mandated reduction in the purchasing power of the dollar (2).
The changes to the monetary system that took place during the 1930s rendered genuine deflation (a reduction in the total supply of money) less likely, while the changes that took place during the early-1970s completely eliminated deflation as a realistic possibility. In particular, once the last official link between the US$ and gold was severed in 1971 there was no longer any limitation on the amount of dollars that could be created by the Federal Reserve System and non-stop inflation became a virtual certainty. It is also worth mentioning that once the amount of dollars that could be created was no longer dependent in any way on the amount of gold in the monetary system there was no reason to prevent US citizens from owning gold, so gold ownership was once again made legal in the US at the beginning of 1975.
The red line on the following chart shows the year-over-year changes in the total US money supply (M3) from 1959 through to January of 2006. Notice that apart from a very brief and shallow dip below zero during the first half of 1993, the year-over-year change in M3 has been positive throughout this entire period. This inflation has, however, had different effects at different times. Sometimes the inflation has boosted valuations in the stock market at the expense of the commodity market -- 1942 to 1965 and 1980 to 1999, for instance -- whereas at other times it has boosted commodity prices at the expense of equities -- 1966 to 1979 and 2000 to the present day, for instance. The point is that inflation is a constant; the things that change are the rate of inflation and the parts of the economy that are the main beneficiaries of the inflation. When confidence in governments and the money they make legal tender is in a long-term decline -- as is the case right now -- then the inflation will boost commodity prices relative to equity prices and boost gold prices relative to commodity prices, whereas when confidence is rising the inflation will boost financial assets (stocks and bonds) relative to hard assets (gold and commodities).
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In an article titled "The End Game" we explained why the inflation not only CAN continue, it MUST continue (regardless of the ramifications for the dollar and the bond market, the Fed has no choice other than to continue the inflation). However, for the current monetary system to remain in place for at least another decade the inflation can't continue in a straight line. Instead, there will have to be periods when deflation appears to be a clear and present danger in order to prevent the dollar's decline relative to hard assets from spiraling out of control and to pave the way for the next round of monetary largesse. During the first half of 2005, with the Fed in rate-hiking mode and the US yield-spread contracting, we thought that 2005-2006 would be a period when deflation fears once again came to the fore, but in that respect the second half of 2005 certainly didn't pan-out in accordance with our expectations. Rather than having trouble continuing the inflation it seems that over the past six months the Fed has had trouble reining-in the inflation; but temporarily rein-in the inflation is what it must do if the world's greatest confidence scheme -- today's monetary system -- is going to survive into the next decade.
(1) Presidential Executive Order 6102, signed by President F.D.Roosevelt on 5th April of 1933, made it unlawful to own or hold gold coins, gold bullion, or gold certificates. (2) On 31st January, 1934, President F.D.Roosevelt devalued the US$ relative to gold by 40.9%. Regular financial market forecasts and analyses are provided at our web site: http://www.speculative-investor.com/new/index.html One-month free trial available.
-- Posted Tuesday, 21 March 2006 | Digg This Article
![](http://news.goldseek.com/SpeculativeInvestor/si.gif) Regular financial market forecasts and analyses are provided at our web site. One-month free trial available.
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