Going up! It may not feel like it, but the inflation lift is moving…

Alasdair Macleod – 22 Oct 2009

The more I talk to people, the more I find that they do not understand inflation. Furthermore, at a time when the Fed has more than doubled the quantity of money in circulation, and the economists are still saying the threat is deflation and not inflation, an understanding of inflation has never been more important. So here are some basics.

Before the invention of a medium of exchange, life was simple. A farmer might exchange a piece of meat from one of his slaughtered animals for a hoe, so he could tend his vegetables. How much meat is required depends on two variables: the value of the meat, and the value of the hoe. Meat may be scarce or in plenty, as indeed may be the materials to manufacture the hoe. The price of one against the other is therefore dependant on two, not one variable.

Fast-forward to modern times. The farm shop will sell you some meat, and you pay it with what both parties accept as money. We understand the farmer’s price will change due to meat prices in the market, which in turn will reflect adequacy of supplies and levels of demand. But we assume what we give the farmer in return, paper currency or an electronic transfer measured in this paper currency, has a constant value.

Governments and central bankers have convinced us that we must not question the value of the money side of this transaction. But they have deluded themselves in order to delude us. Money is at least as likely to vary in value as the joint of meat in our example. Money is itself a commodity, whose value rises and falls all the time, against other currencies, commodities and even finished goods. It is important to understand this.

Let us say that, rather than there being a shortage of meat, there is a shortage of money. In this case, the price of meat expressed in money terms will fall, because meat is more plentiful than money. The reverse is also true. If money is more plentiful than meat, the price of meat in money terms will rise, because money is more plentiful than meat. Stated this way, it is obvious that the price of meat depends on two things, the quantity of meat in the market, and the quantity of money in circulation.

However, if the prices of a majority of products commonly exchanged for money move in the same direction, we more easily accept the hypothesis that money’s value has changed. The government will now imply that the opposite of money holding a constant value is now true: they now act through monetary policy as if the prices of goods in aggregate are constant, but the value of money has changed. The mistake that is common to both positions is that they only look at one side of any transaction.

General price levels change as much as individual prices. Government can itself suppress demand for goods and services by increasing taxation, because taxes paid or money set aside for taxes will lessen the amount of spending available for goods and services. Crowd sentiment can swing demand for goods and services from extremes: from borrowing to buy them, to doing without to save. Changes in personal wealth through changes in asset prices are very much part of this sentiment. Swings of this sort have nothing to do with changes in the purchasing power of money, and are entirely due to changes in demand.

Unfortunately, governments and central banks make no attempt to understand the distinction. They act as if a change in general price level is entirely due to changes in the value of money. It is on this basis they seek to manage changes in consumer prices through monetary policy. This is at the heart of confusion between inflation and deflation. In an economy with a deteriorating outlook, prices will fall due to lower demand. They do not fall because of insufficient money. By printing money, it may be possible to offset prices that are falling due to lack of demand, thereby creating the illusion that values of goods and services have not fallen. But what happens when prices stop falling, merely because a balance between supply and demand is found? The value of money priced in goods will continue to fall, and the net effect is that prices will begin to rise.

There is another trap that governments have sprung on themselves: zero, or close to zero interest rates. Negligible interest rates are a strong disincentive to saving, since there is no compensation for risk, which at a time of increasing insolvency amongst borrowers and therefore banks, and at a time when money is being blatantly printed, is the greatest mispricing of money possible. Remember that money is a commodity subject to supply and demand in the same way as the farmer’s joint of meat.

With the disappearance of savings, government finances, in the UK and US at least, are now entirely reliant on the printing of money. This is done bluntly through quantitative easing, where the central bank prints money to fund the budget deficit, or through less direct means whereby the central bank creates the money and credit for the commercial banks to lend money to the government. Both these roads lead to the oversupply of money and its close relative, credit; it is a transfer of value from money already in circulation to new money, decreasing its value accordingly. The trap that has been sprung is that sooner or later the falling values of this paper money will no longer be masked by the value effect of falling demand for goods and services. At this point the combined measure of these two components, expressed as price indices, will begin to rise.

We shall consider the circumstances when this is likely to occur in a moment. For now, the question is how will governments face this new threat of rapidly rising prices, now that they have become totally reliant on inflating money and credit to support their own finances? How can government withdraw its stimulus to the economy without deepening the slump? This is the dilemma that has faced every bankrupt state since the invention of a government-controlled medium of exchange. The over-riding concern will still be seen to be deflation. All it will take is one more financial shock, or for the inventory-led recovery to peter out and we will face a debt-deflation collapse.

This concern is of course valid and as an outcome is even likely. But the debt-deflation collapse refers to the effect of falling collateral values on consumer and corporate debt, not on goods and services. It is true that the impoverishment of the private sector by the loss of its capital will reduce demand for goods and services, but the effect on supply is being neglected. Small and medium size businesses, which cannot be rescued in such a down-turn, would be badly hit, eliminating productive capacity. A sharp acceleration in their bankruptcies will begin to interfere with their collective supply of goods and services, and disrupt the supply chains of the larger companies. This is what leads to a shortage of goods in a failing economy where there is too much money, and if we regard money as merely a commodity used for the purposes of exchange, it is easy to anticipate the result: stagflation, or even hyper-inflation.

The likely severity of future price inflation can be guessed at by looking at the inflation of money and credit so far. There is no fixed relationship because there are three unquantifiable variables. As well as the variations in the values of both goods and money there is the morphing of money into credit, and vice-versa, which serves to confuse the picture. However, given that the Fed has inflated the monetary base for dollars by about 100% in the last year, price inflation has the potential to be substantial.

The current means of controlling inflation will add to the problem. Central banks regard changes in consumer prices as representing the inflation rate, and make no attempt to distinguish between the effect on prices from changes in the supply and demand for goods and services, and changes in the purchasing value of money. Not only are they unable to do this, but they are basing today’s actions on historical trends. Since there is always a time delay in the early stages of inflation between the printing of money and its effect on consumer prices, consumer price history is simply not relevant to the task and is misleading.

So we can see that even in the event of a debt-deflation spiral, prices in goods and services after a brief period may begin to rise alarmingly. If this is so, why did this not happen in the 1930s? The answer is simple: the major currencies operated a gold standard, which was the limitation on the amount of money and credit central banks could produce. Without an independent or rival medium of exchange, it has been normal for the sequence of events to lead to a currency collapse. There is no gold standard today, and indeed, central banks relish the freedom from this constraint. It is increasingly difficult to see how such a collapse in the value of paper currencies will not eventually happen.

The answer to the deflation/inflation question is that we will probably suffer both, but inflation is the greater problem. Technical analysis suggests a strong possibility that oil prices, will rise towards $100 in the coming months. Whether this actually happens is not the point, but it reminds us that prices of vital commodities such as energy and food are beginning to rise, since the price element due to demand is no longer falling at a rate that offsets the fall in the currency’s purchasing power. Deflationists should take note.

Surely, it will not be long before markets begin to concern themselves with the first inflationary cuckoo of spring. The consequences of this discovery could be profound. The pricing of money will slip out of central banks’ hands, with interest rates along the yield curve rising from their artificially low levels. To have the central banks wrong-footed by the markets will expose their weakness, and is very different from the last bout of global stagflation.

The world’s central banks dealt with the inflation and stagflation of the seventies and eighties by raising interest rates, and pricing money correctly. At least the authorities were able to take the correct action before markets forced it on them. It took many years for this medicine to work, for other reasons beyond the scope of this article. This time, a deliberate switch of monetary policy to high interest rates to control monetary inflation is a far tougher action. The scale of the financial and economic problems today is at least one magnitude greater.

The world was a lot simpler when you could exchange meat for hoes: at least you knew the value of both.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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