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Prices are About to Follow Inflation

Thursday, June 26, 2014

The truth about inflation is about to start becoming clear.

I know, I know... the eyes roll and glaze over... here we go again...  But there are so many things either going on right now, or about to start, that are interconnected.  And we simply need to know how they are interconnected if we are going to be able to respond positively as neighbors.

Understand, I am not really concerned about whether you are registered as a Republican, Democrat or Independent.  Even though I believe labels matter, I am not even really interested in whether you would pin onto your shirt the 'liberal' or 'conservative' label if we were giving out such name tags.  I am mainly interested in engaging my neighbors in a conversation about all of the things happening today, how they interrelate, and what we can do together as neighbors about them.

'Money' and 'Price'

And as we see prices starting to rise, the first thing we have to wrap our heads around is this: Money and price are not the same thing.  When you read the story linked to above about inflation, the first thing you have to realize is the classic definition of inflation has nothing whatsoever to do with price.  Inflation is when the addition of new money into the economy, as a percentage, increases ahead of the growth of the economy, also as a percentage.  If the economy is growing at 2%, but the money supply is growing at 20%, inflation is the difference - 18%. (I am using these numbers as examples.)

When 20% more money starts chasing only 2% more production, an increase in prices follow.  But it is crucial that we understand that this increase in price is not what causes inflation; it is the other way around: inflation is what will cause the increase in price.

But we have been told for years now that inflation is low, right?  What we are really being told is that the Consumer Price Index (CPI) - which excludes the prices we notice most, like food and energy, has only been increasing by less than 2%.  That is about to change.  But it is crucial we understand two things: 1) why this CPI number has remained low to date; and 2) why it is going to start running higher.  This requires we understand the difference between money and currency.

'Money' and 'Currency'

Blink a few times right now, if only to get that glaze off of your eyes :-)

I am going to start using terms like 'money' and 'currency' a little different than the 'experts' use them.  This is because, one, I am not an 'expert'; and two, I am not writing for 'experts'.  I am writing for my neighbors.  I do this because I refuse to sign on to the notion that the faculty lounge gets to tell the rest of us what words mean.  If by using these terms in a supposedly wrong way succeeds in enabling the rest of us (as opposed to the 'experts') to start talking about our money, what it means, and where we need to go with it in the future, then any criticism I might get for this will be well worth it.

Nothing has changed the economy more dramatically than the computer.  It used to be that if we wanted to increase the money supply we had to crank up the printing press and print more dollar bills. Now all we need are a few keystrokes or mouse-clicks.  This might seem outlandish, but it is true.  The Federal Reserve has increased the money supply by simply adding to their computerized central 'bank balance' and then using that new money to buy up mortgages and government debt.  These mortgages and government 'bonds' were sold to the Federal Reserve by the major banks.  As a result, the major banks are sitting on all this new money.  But the economy has only been growing by between 1% and 2%.

The banks understand that the Fed cannot keep up this creation of new money forever.  Indeed, the Fed continues to lower the amount of new money created each month.  The banks also know this means higher interest rates at some point.  The logic is actually pretty simple.  If you have money to lend, but can only get 2.5% for that money today - and you have reason to believe that interest rate will rise - why lend it out today when you can get a higher rate for your money tomorrow?

It ends up being a game to see who can wait out the other.  The commercial banks are trying wait out the central banks.  This is why we have not seen a broad spike in the CPI yet.  This is also why the European Central Bank is now charging commercial banks 0.10% (instead of paying interest as it usually does).  The Fed only pays 0.25% (which explains why you only get 0.01% on your savings account).  The point of the game - for the central banks - is to get the commercial banks to lend out all of this excess money.

And they are starting to do just that.  If you have noticed that packages do not contain as much product as they used to you are seeing the first effects of this.  Inflation will show up in lower volume before it shows up in higher prices.  But as the news is starting to report, a broad rise in prices is just starting to show up in the Consumer Price Index.  The only way the Fed can respond to this to keep inflation from running out of control is to hike interest rates.

At that point these commercial bank reserves - which have only been zeroes on a bank statement somewhere - will end up in a company's bank account.  And they will go from there to an employee's bank account and from there to an ATM; the 'money' becomes 'currency' and starts to chase the same amount of products and services.  A significant and broad spike in prices is the inevitable result.  It will become painfully clear soon that the Federal Reserve will not be able to contain this price spike merely by increasing interest rates.

'Money' and 'Wealth'

If you haven't yawned yet, please, by all means do so now...  But please stay with me, because it hasn't always been this way.

Back when the dollar was tied to gold and silver (remember the 'silver dollar'?) the money supply was constrained by the amount of gold and sliver held by the Treasury in reserve.  What this meant was those dollar bills in your wallet were a stand-in: they represented your claim on the gold and silver held by the Treasury on your behalf

This is hugely important: Because the money supply was tied to gold and silver held in reserve on behalf of the American people, the money supply represented the wealth of the nation - meaning everyone from the banker to the cab driver.  At the start of the Civil War, though, to finance the war the U.S. took the dollar off of this gold and silver standard.  The bills in your wallets used to be "gold-backs" or "silver-backs" (meaning they were "backed" by gold and silver).  When that tie was broken to be able to print money for the war, those dollar bills got the nickname 'green-backs' - they were "backed" by nothing other than green ink.

After the war, Congress restored the tie, but only to gold.  That 'gold standard' remained until 1971.  The demise of the gold standard then put us on this inexorable path to what we now have: over 17 trillion dollars of public debt.

As I have noted in other posts, income inequality should not surprise us; when the economy is dominated by an excess of credit why would anyone be shocked to see the creditor getting excessively rich?  The people to whom you owe money will always have more of it than you.  And the more you owe, the greater this disparity will be.  But this is driven by a much more fundamental reality: Our money no longer represents the wealth of the nation.  The dollars in your wallet now represent the wealth of the banking sector.  As former Treasury Secretary Timothy Geithner's new book Stress Test makes very clear, the money supply was increased to save the major banks.  It was also increased to save the government from an increase in borrowing costs.  Usually we think of taxes as dollars from our paycheck.  But when the money supply is inflated to save the banks and prop up government borrowing, the dollars in your wallet are robbed of their purchasing power; taxes are now food from your table.

Back to the Future?

Is your head on the desk yet?  If you were a jock in school I would be tempted to let you sleep through the rest of this... Actually, no, we're neighbors and I'm really sorry but please believe me, you need to know these things... if only for the benefit of our kids' future.

Part of what makes topics like this hard to discuss is that certain names are recognizable only to those who are old enough to remember the events and circumstances from which these names came to be known.  This is true, for example, of Ronald Reagan.  Conservatives love to refer back to him.  The problem is an increasingly larger share of the population - our neighbors - are not old enough to remember him.

The same is true for Paul Volcker.  Right before losing the 1980 presidential election, President Jimmy Carter appointed him to be the Chairman of the Federal Reserve.  I am barely old enough to remember the inflation of the 70's, so his name brings back memories.  He immediately began 'hitting the brakes' on the nation's money supply by raising interest rates.  This did two things: it reduced inflation dramatically; and it recalibrated the money supply to objectively productive uses (stay tuned, I'll write about this next week in "Monetary Orientation: Financing 'Team Noklu'").  It also caused a two-year shock, of sorts, where we went into recession and unemployment spiked.  But the years that followed brought tremendous prosperity.  Unemployment dropped from double-digits to about 5%.  Prices stabilized, allowing most Americans to actually enjoy the fruits of the prosperity as the purchasing power of their dollars was protected.

But unlike Reagan, Volcker is still with us, and recently weighed in on our current economic issues.  Again, these things are really difficult to discuss when you throw terms like 'Bretton Woods' around.  Most, of course, have no idea what that means.  The simple answer is that 'Bretton Woods' is a term used to describe a system which tied currencies to a precious metal like gold.  This system was set up after World War II as part of how Europe was rebuilt after the war.  It fell apart in 1971 as a result of the combination of the Vietnam War and the Great Society (older folks will remember this as "guns and butter") and the beginning of the now 40+ year old pattern of deficit spending.

Volcker is calling for a return to something like Bretton Woods.  While he did not come out and call for a return to the 'gold standard', the fact that he is presenting "A New Bretton Woods???" as a question for debate tells us that he sees how our money supply is managed as the fundamental problem we face today.  If you have read other posts in this blog (e.g. the one on the minimum wage, and the 'toilet paper outrage') or the Chapter 5 series in my book, you will not be surprised to see me point your attention to this.  But even if this all seems well outside your interests (meaning you are getting really bored right now, sorry) please bear with me.  It really matters to other issues that might interest you.

The minimum wage, for example, is a real problem.   But it is not because the CEO is making more than the cashier, but because the dollars in which that minimum wage is paid buy less and less.  Thus the problem is not really a problem of wages, but of the money those wages are paid in.  Regardless of whether you are working a minimum wage job right now, if you are making wages of any kind, this should matter a great deal to you.  This is why we have to take the time to understand what Volcker is trying to say.

And the reason we need to listen to him is because he is old enough to remember when we didn't have deficits.  We have been playing this game with our money for a little over 40 years now, and Volcker has watched the game from the start (in some ways he was responsible for starting it).  He is pointing our attention to the fact that our modern system of money has not accomplished what he and others thought it would.

Bored Yet?

OK, OK, I am done.  Stop banging your head on the desk already.

So where does this leave us?  Why bore you to tears with all of this?  Because in a couple years we will begin paying attention as candidates run for President.  While I am not much interested in endorsing candidates, I am very curious to hear what Senator Rand Paul has to say because he comes from the 'school' which believes we need to return to 'sound money'.  That 'school' has been out of favor with economic 'experts' for quite a while - until now with Volcker's speech and articles like this and this and Steve Forbes' new book Money: How the Destruction of the Dollar Threatens the Global Economy.

If your memories of the last financial crisis are still fresh enough to worry about what the next one will do to our kids' economy, this subject merits your attention.  Please, read, and read a lot (like this from Milton Friedman).  Get as smart as you can as quick as you can about our nation's money supply.  We will likely have the opportunity to make an incredibly important decision about it in the coming years.

[Stay tuned!  Next week I'll write about what happens when the economy is flooded with all this excess money in "Monetary Orientation: Financing 'Team Noklu'"]

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