As I spoke about in an earlier post, the type of money used in all current modern monetary systems is created through debt. For purposes of our discussion, this means loans which originate at banks are the source of monetary creation. Since private loans do not create money, we are only interested in money creation through the loaning function of duly sanctioned banks.
Fractional Reserve Banking
It is very important to understand how we have come to this place in monetary history.
Economic lore surrounding the genesis of modern banking suggests a discussion of medieval goldsmiths and their vaults. Common sense dictates wealthy persons, possessing monetary metals as a valid store of wealth, would seek safe keeping for their valuables. At that time, goldsmiths – those who actually worked gold into coin – were a logical choice for this task since they already possessed the vaults and other security measures.
When depositors left their money with the “original bankers”, they were issued a receipt which was redeemable on demand. Soon thereafter, these receipts circulated as a medium of exchange among merchants.
We define money as some “thing” which served as a medium of exchange and a store of value. Since the receipts were redeemable on demand from the banker, they were essentially as good as the commodity (gold) itself. The receipts also functioned as a store of value for the same reason. These receipts therefore, became a form of paper currency.
The original bankers were not stupid. They noticed their receipts were circulating as a medium of exchange. And they also noticed only 10% of their depositors ever came to regain the receipts for actual gold. With this in mind, bankers decided to issue receipts and loan them at interest. And fractional reserve banking was born.
Modern Fractional Reserve Banking
Whether the above account is accurate is not important because fractional reserve banking exists today, only with a different twist. I again direct you to the Modern Money Mechanics essay. I urge you to take repeated steps to familiarize yourself with that material.
So let us begin at the Federal level. For example, the Federal government asks the Federal Reserve for treasury bonds in the amount of $1 billion. The Fed then draws a check on itself and places this deposit in its own account. The Fed then enters the amount as both an asset and a liability on its balance sheet. In this way the government, through the act of borrowing, has increased the money supply by the amount borrowed. Of course, if you or I did this, we would be thrown in jail, but that discussion is for another time.
The Federal Reserve then uses its “assets” to loan to other banks within the system. These banks, borrowing money from the FED, offer loans to other banks and ultimately to the public at interest. Keep in mind the amount of interest in NOT created but only the loan amount.
Debt Money and the Economy
Classical economic theory places the determination of the amount of currency in circulation in direct proportion to the amount of production present in the economy. In other words, there should only be an increase in money supply if more production warrants the increase. Today’s money creation has little in common with this practice.
By way of example, let us say the US Government is a little short this month, desiring to spend more than it takes in taxes. The Government goes to the Fed and asks for a billion dollars. The Fed gives them the equivalent of a check or credit for 1 billion dollars payable to the US Government.
Then, let us say the government official takes the check and deposits it into the government account, which is also at the Fed and begins to write checks on the deposit for things such as Medicare/aid, social security, government paychecks, government contracts, etc.
In the above scenario, the amount “needed” in the economy is NOT increased by a commensurate increase in production. No new goods or services entered the economy. Instead, the increase comes from debt. Of course, it could be argued the debt will lead to production. And that could be true in the case of business loans used to increase revenues. But the opposite could also be true – that the debt will ultimately be used for consumption. And we see this every day with government benefit spending. We also saw it in the mid 2000’s when people were refinancing their homes and extracting cash to pay for consumables.
I do not want to get into a discussion as to the merits of this monetary system. It is our system. There is no use fighting it. When its time comes, I am quite sure it will be replaced. Maybe its replacement will change the investing rules – maybe not. But for now it is still our system.
For our purposes here, we need only recognize that banks loan a great deal more than the money they hold on deposit. We also need to recognize how the money is created through the act of borrowing because through this knowledge we can understand the effects of this system on asset value.
Inflation as a Monetary Phenomenon
Economic theory is consistent in the theory of adequate money supply. That is, in any economic system, there needs to be an adequate supply of money to facilitate commerce. This liquidity is necessary so trade within the economy can continue as quickly as needed.
When the amount of currency is consistent with the amount of production within the economy, we can conclude the value of any given unit of currency is stable. Most economists, particularly those with an Austrian school background, view an inordinate increase in money supply as inflation, a sort of “stealth tax” levied on the purchasing power of the entire currency. They regard inflation as a wealth transfer mechanism moving wealth from the productive class to the ruling class.
Although many view inflation as an economic phenomena caused by fluctuations of supply and demand, Austrians scoff at this view. According to them, inflation can be caused ONLY by a disproportionate increase in money supply. They argue if true supply and demand relationships were unaffected by governmental monetary policy (in other words, over printing of money), the price structure of almost any commodity would decrease due to better manufacturing, more efficient distribution, etc.
Regardless, inflation exists and it is important to understand this when investing your money. High inflationary numbers are made possible by fiat currency and the creation of currency through debt.
In a previous post, we discussed the idea of credit-based money. And you will also remember fiat currency has no commodity backing. However, please note that under a commodity standard 10% reserves (gold and/silver) was perceived ample stability since the currency was backed by real value and the money was already accepted in commerce.
The original Federal Reserve Notes were no exception to this commodity backing. The notes were originally backed by gold. In 1933 President Roosevelt in a declaration of national emergency confiscated the People’s gold. He then set the price and supposedly put the Nation’s gold in safekeeping. As a result of that transaction, Federal Reserve notes were no longer redeemable in gold or silver to citizens.
Foreign governments however still maintained this right until 1971 when a perceived overprinting of money for various Federal purposes (i.e. “guns and butter” and the Great Society) caused downward pressure on US dollar. As a result, other nations, most notably France, demanded gold as payment for their US Dollar reserves. Faced with a potential currency crisis, President Nixon refused to redeem dollars for gold and thereby “closed the gold window” for everyone including foreign nations. (See The End of Dollar Hegemony, Congressman Ron Paul’s (R-TX) testimony before the House of Representatives describing the history of Federal Reserve Notes).
Nixon’s closing of the gold window was the final step in removing any tangible value from the US dollar. And if the power structure showed restraint in plundering the purchasing power of the dollar, no one might have noticed. Instead, many people did notice and a decade-long bull market in precious metals and interest rates ensued.
Of course, I am painting broad strokes here but the point is that commodity money had become fiat money. This changed the fundamental characteristics of the currency. Had you been around at that time, and understood what was going on, you would have known what came next: inflation across both consumer items and assets.
The reason these points are important is because by removing any tangible value from a unit of currency, the purchasing power of this unit was at the mercy of those in charge of printing it. The result was an enormous increase in federal spending and subsequently an increase in central government. And while many citizens gain benefit from the spending, the bill still must be paid. The payment comes from everybody’s pocket and in the form of inflation.
There are differing opinions on how to define inflation. Austrian economic thought says that inflation is an increase in the money supply in disproportion to the increase in production. Others define inflation as an increase in the general price level in the economy. Regardless of the definition, there are different ways to calculate inflation. Let us explore some of these below.
Consumer Price Index (CPI)
According to the US Department of Labor (DOL), “The Consumer Price Indexes (CPI) program produces monthly data on changes in the prices paid by urban consumers for a representative basket of goods and services.”
So the purpose is to track a change in price either higher or lower. In most instances, and for the reasons set forth above, prices generally trend higher. Accordingly, for most people, the CPI Index is largely used to measure inflation. Even the Federal Government, when adjusting benefits payments, uses the CPI in calculating the adjustments. Here is the link to the FAQ page on the CPI website.
The index measurement is derived from “urban” prices for a specified basket of goods and services. The basket includes the following:
- FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, service meals and snacks)
- HOUSING (rent of primary residence, owners’ equivalent rent, fuel oil, bedroom furniture)
- APPAREL (men’s shirts and sweaters, women’s dresses, jewelry)
- TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
- MEDICAL CARE (prescription drugs and medical supplies, physicians’ services, eyeglasses and eye care, hospital services)
- RECREATION (televisions, pets and pet products, sports equipment, admissions);
- EDUCATION AND COMMUNICATION (college tuition, postage, telephone services, computer software and accessories);
- OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal services, funeral expenses).
Recently, the Federal Government has been using the “Core CPI” which excludes, or at least limits the use of energy and food prices in the calculation. The reason for this is sketchy, at best. The argument states the prices for food and energy are too volatile to give an accurate measure in price increases. Because rapid price fluctuations may occur because of trading or other economic conditions, these items are minimized in their use.
However, the price of everything depends on energy. And everyone must also eat (also energy). So to exclude a line item in the cost of everything is suspect. I can imagine multiple scenarios as to why the Feds shy away from the truth. Government statistics have unfortunately become poor indicators of true economic conditions.
If we define inflation as an increase in the supply of the currency without a commensurate increase in economic production, then perhaps a look at the broad money supply as compared to the Gross Domestic Product (GDP) could lend a helpful hand in our quest to track inflation.
M3 was the broadest supply measure given by the FED (no longer reported). Other measures include:
- M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.
- M1: M0 – those portions of M0 held as reserves or vault cash + the amount in demand accounts (“checking” or “current” accounts).
- M2: M1 + most savings accounts, money market accounts, and small denomination time deposits (certificates of deposit of under $100,000).
Using the various series in comparison to the GDP can give a somewhat accurate picture of inflation. Economagic.com offers a chart series entitled Velocity of Circulation. This chart measures inflation by dividing the broadest money supply figures by the GDP.
Gold bugs everywhere think of gold and silver as monetary metals. Since gold and silver were the primary backing for every successful currency throughout history AND every fiat currency has historically failed, gold enthusiasts say the best measure of inflation is the metal’s price.
I agree that the gold standard is a safeguard against inflation. However, tracking inflation against the currency being inflated is ineffective. I refer you to the chart below (courtesy of Kitco.com). If gold were a true indicator of inflation, the price would probably look a great deal like the CPI line graph shown previously. Instead notice the up and down action in the price of gold over the last several decades.
You can see the price explosion a couple of years after President Nixon closed the gold window. But also notice the approximately 45% retracement which occurred since 2011. The gold price in dollars does little to help us in our quest to measure inflation because of this volatility.
The Postage Stamp
My favorite method of calculating inflation, although perhaps not the most accurate, is to use the price of the postage stamp. This is because the price of a stamp includes the price of energy. However, arguments can be made that government enterprises are not efficient and therefore to measure inflation this way gives only a vague idea of inflation. Of course, you could say any individual item would be a poor choice since things like supply/demand dynamics or governmental waste are always in play. And I would agree. I suspect that is the reason why the CPI tracks a basket of items.
I maintain that to understand inflation, you must see the purchasing power of the currency deteriorate. With that in mind, the US Postage Stamp is as good an inflation indication as any other. So let’s take a look.
You can see the deterioration of the US Dollar in this graph. Notice the rapid increase in price after Nixon closed the gold window in the early 1970’s.
Overall, if the government agencies were in the business of telling the truth, I would just assume use the CPI. I have my doubts however, that is why I use all of the above to get a “feel” for our inflationary climate.
Economic Imbalance, Waste and Bubbles – The Result of Monetary Policy
As we can see, inflation erodes the purchasing power of each unit of currency. However measured, you also must understand how governmental policy effects money.
Money has always been the primary concern of governments. Modern sovereigns are no exception. When the supply of money is not commodity backed, social programs such as Medicare, Medicaid, unemployment insurance, welfare, and many others are possible. And it is easy to see how it comes about.
Someone stands up and shouts, we should do something about drugs, crime, terrorism, health care, global warming, or just fill in the blank. The government entity appoints a commission to conduct a study on the problem and make recommendations. The commission studies and finds there is, in fact, a problem and makes recommendations. The government then contracts with a third party to see through the recommendations, paid with borrowed funds or taxpayer money, or both. Often time the commission and the contractors are the same people, appointed as “experts” in the field, so they are given the contract. Many a connected person has generated a fortune in this manner. It is just too difficult to resist.
Arguably the above scenario is played out thousands of times. Not only is the overpricing of goods and/or services wasteful but worse, the money cannot be allocated to other productive ventures. Yet the price must still ultimately be paid. And that price is inflation.
Another result of monetary policy is the financial bubble. Also known as a speculative bubble or financial mania, a “financial bubble” is characterized by large trade volumes at a price way out of whack with historical intrinsic values.
For example, a share of stock has historically traded at 10 – 20 times its Price to Earning Ratio (P/E Ratio). In the late 1990’s, many stocks on the NASDAQ traded at 50 times the P/E at tremendous volume. The average P/E for the SP500 shot above 40. Current DJIA pricing is out of whack with traditional valuation models as well.
The cause of these bubbles is certainly disputed. Some “experts” believe it is simply caused by human nature and greed – the nature of men to be overly optimistic in bidding up prices over short periods of time. Once the mania begins, it generates its own momentum.
I submit to you however, this is just but one factor. The main factor, in my opinion, is excessive monetary liquidity in the financial system. By lowering interest rates, thereby increasing borrowing, the Central Bank (FED) causes an influx of liquidity in the system. The money must find its way somewhere and always does. The result of this type of monetary policy always results in inflation. This is the beginning of the bubble. In my opinion, without this rising of prices, the other explanations do not even come into play. No one is becoming irrationally exuberant over stagnant prices.
The asset bubble usually features an exponential rise in the pricing in a relatively short period of time. The drop is almost always as quick as a crash erases relative value.
Now there is good news and there is bad news. The bad news is that there is a constant eroding of the purchasing power of the currency. The good news is that this same inflation offers an incredible opportunity to those who recognize inflation and what it does. We will explore some of these very opportunities in later posts. For now, let us be sure of the following:
- Fiat money is not backed by anything tangible. It is borrowed into existence and this process is ripe for abuse for people borrow and spend disproportionately creating money before it is warranted by economic production. The result is inflation.
- Banking is at the center of the Monetary System because through the banks money is created.
- Inflation is an economic reality. And creates “asset bubbles” in various markets according to the conditions at the time.
- A variety of methods exist to calculate the inflation rate. Perhaps a compilation of many different methods gives an accurate “feel” of the inflation rate.
- Any evaluation of Rate of Return (ROR) must factor in the effects of inflation.
Thank you for your interest, and thanks for listening.