The Inflation Tease

The principle of inflation in economics is actually not much different than the principle of inflation in physics. When a balloon is inflated with hot air, for example, we see a very large increase in volume without any appreciable increase in mass. Similarly, in economics, inflation represents an increase in monetary supply without the corresponding increase in the value of that money. It looks like growth at first, but like a Ponzi scheme, it’s only a matter of time before the bubble pops and a correction occurs and everyone sees what’s really there; thin air.


There is no perfect way to measure inflation, but many different indicators exist. The most commonly accepted indicator is the Consumer Price Index (CPI); a sampling of the prices of the most commonly is purchased consumable goods. Using this indicator of inflation, the CPI chart indicates a step change in slope around 1971, the year the gold-based Bretton Woods system was officially abandoned because it was preventing government from running large deficits. The average annual increase in CPI jumped to a 4.6% average annual rate of increase from a more stable 2.5%.


The cause of inflation is a significant increase in money supply. Imagine playing a game of Monopoly where the bank decides to add a zero to the end of every new note it issues. Pretty soon, the old money becomes useless and each player would be forced to raise the selling price of his or her properties to reflect this new reality. It wouldn’t be so bad if we just added a zero to the end of every note, but the way it happens usually benefits some people quite a bit more than others. The first person to pass ‘Go’, for example, would find themselves flush with cash, and would likely go out on a spending spree. By the time the player in ‘Jail’ realizes what’s going on, he will probably have sold off all of this properties for what he thought was a great price, when in fact he got ripped off. This is exactly what happens in the real world, the first people to get the increase in money supply—the large financial institutions, hedge funds, very wealthy and so on, get to spend the new money at old prices. By the time this money gets into the pockets of the middle class and the poor, prices have already increased and they simply find that their savings have been rendered worthless. This is exactly what we are seeing today—wage depreciation occurring at the same time that consumer prices are either increasing or staying flat.

It’s no surprise that central banks such as the United States Federal Reserve, a pseudo-private, pseudo-public entity which is essentially run by banks and backed by government, makes their policy that creates the biggest benefit to their friends at large financial institutions. Government, which essentially owns (but does not directly operate) the central bank, is usually complacent to this policy because inflated economies look good—at least until the bubble bursts. And yet no president including Regan has been able to successfully balance recessionary and inflationary forces since the idea of having a naturally stable currency was abandoned in 1971. This is the main argument for why central banks should be abandoned—government has proven itself incapable of maintaining a stable currency in nearly four decades since it decided it could do a better job of this than free markets could.

"I'll bet you a lot more than a penny" - Peter Schiff predicting the credit crisis and collapse of the purchasing power of the USD (2006).

This reality is often underreported by the mainstream American media. Some claim this is because the media, including many so-called experts and economists, are mislead by the way the government reports on it's monetary policy. For example, the U.S. Federal Reserve decided to stop reporting M3, the total money supply in March of 2006, claiming the data was too difficult to accurately compile. It still reports M2, which is part of the money supply, but the M3 wedge has grown from less than 5% in 1971 to over 30% of the total in February 2006 when this figure was last reported (see chart). Not everyone is fooled though. The video below shows economist Peter Schiff on major U.S. television networks predicting the subprime and credit crises in 2006 and 2007 despite being ridiculed by his naive counterparts at the time. It is also worth noting that these counterparts recommended buying equity stake in firms like Bear Sterns, Merrill Lynch and Washington Mutual, all of which became insolvent and were forced into distressed mergers with more solvent financial institutions. Each of these transactions was facilitated by either the Federal Reserve or the Treasury with some kind of taxpayer-backed debt guarantee or subsidy. Hopefully these guys stay low-key for awhile until people forget how bad their recommendations really were. Enjoy watching the video.