Thursday, January 8, 2009

What is Inflation?

Prices rise over time. Today, people call this general increase in prices, “inflation.” In the past, however, when the government created new money, people said the government was inflating. Whenever the government inflated the amount of money, there was a general rise in prices.

Before we discuss inflation, it is important that we have a firm grasp on what money is.

Before there was money, there was barter, or direct exchange – my wooden club for your piece of sharpened flint, or my goats for your daughter. Direct exchange is problematic because, among other things, you may not be able to find someone who wants to trade what you want for what you have.

At some point, people began to engage in indirect exchange. I want bread and I have candles, but the baker doesn’t want candles. So, I ask the butcher if he wants some candles in exchange for some meat. If he agrees, I can exchange candles for meat. Then, I can exchange the meat for the bread that I actually want. The meat has functioned as a medium for the exchange.

Some things are more easily traded away than other things. The things that are most easily traded away eventually become desired exactly because they can be easily traded away and become a medium of exchange or money. This is how money begins. Dried fish, pelts, dried tobacco, seashells, and other goods have been used as money. The most famous monies are gold and silver. Note that, even though the function of money as a medium of exchange does not require that the money be useful for anything other than exchange, a medium of exchange cannot come into use without first having had a direct use for consumption.

The earliest form of inflation occurred when kings would debase gold or silver coins. Since people naturally exchange gold and silver coins on the basis of weight and purity, the names of coins used are simply weights. The British pound sterling was a (physical) pound of silver, for example. The king begins the process of debasement by first minting coins of pure gold or silver and calling them by some official name which is not a unit of weight. For example, the Romans called their monetary unit the denarius. The king then bans all other forms of money or – more commonly - requires all taxes to be paid in the official unit. To pay taxes, the individual holding unofficial (and probably pure) coins has to trade these to the king to get official coins to pay the taxes. The pure coins are melted down and minted into more official coins, which reduces the amount of unofficial coins in circulation and increases the amount of official coins. Eventually, the official coins dominate the circulation. The official coins that are collected in taxes are also melted back down and reminted at a lower purity than before – this is called debasement. This allows the king to spend more than he collects in taxes since taxes are unpopular and can lead to revolt.

Now, it should be clear that debasement is fraud. When the king mints more coins with the same amount of precious metal and decrees that the new coins with less precious metal are worth the same amount as the old coins with more precious metal, he is committing fraud by any other name. But who is the king defrauding and how?

When the king rides out into the market with his newly minted debased coins, the prices which merchants are charging reflect the value of the old, less debased coins. When the king goes to buy a sword or a horse or some other item, he gets to purchase it with less valuable coins but at the old prices. Since the king’s spending is greater than his taxation, he is injecting money into the local economy. As a result, the vendors and merchants the king buys from receive a boon. They should be happy that the king is spending his newly-minted, debased coins with them since they too will get to buy things at the old prices with the new, less valuable coins. As the additional coins are spent and respent, there is “more money chasing the same amount of goods” this means that more coins must be offered for the same goods. Eventually, once the effects have rippled out, prices will be a fraction higher. Those who never got to use the new coins now have to pay higher prices, but still only have the same amount of coins to their name. They now have less effective buying power but the king and the vendors and merchants he spent his money at had greater buying power with the same money. It should be obvious what has happened – buying power has been transferred from the late (or never) users of new money to the early users of new money.

Modern inflation, however, is more sophisticated than simple dilution of the amount of precious metal in a coin. To truly understand modern inflation we must first understand banking.

Banking originated with what we today know as secure storage and pawn brokering. A wealthy man needed a secure way to store his money and confidence that he could recover the money when he needed it. The secure storage of coins or other valuable artifacts was made possible with the ability to issue receipts – if the trusted party tried to steal the stored valuables, the receipt could be used to prove the theft.

Pawning or brokering enabled individuals to obtain loans by using their valuables as collateral against default. If I want to borrow 100 coins, I might deliver my horse to the pawn broker with an agreement to repay the loan with interest or forfeit the horse. In this way, I can temporarily convert my valuables which are not useful for exchange into money which is useful for exchange. When I am done using the money – perhaps to buy something and resell it at a profit – I repay the loan, with interest, and recover my valuables.

When depositing coins into a secure storage, the storage may either issue a receipt or make an entry in its books for the amount of the deposit. The issuance of receipts is the origin of paper money. The book entry is the origin of checking accounts.

When a secure storage becomes used widely enough, its receipts take on a value for exchange independent of the money stored. Anyone who recognizes and trusts the reputability of receipts issued by Bank XYZ will be willing to sell goods or services in exchange not for coins, but for a receipt from the bank. And individuals who both have deposits with the same bank can draft checks which instruct the bank to transfer money from one customer’s to another customer’s account.

Obviously, secure storage of money or other valuables is a trust relationship, where the depositor is the vulnerable party. A secure storage which issues receipts can steal from all users of its receipts by printing false receipts and using them to pay its own expenses. Or, it can steal from specific customers by making fraudulent withdrawal entries in the customer’s account and stealing the deposits for its own benefit. Directly defrauding individual customers by entering fraudulent withdrawals into their accounts is the riskiest way to steal since those customers will know they have been defrauded and will spread word and seek justice for the theft.

However, if the bank operates not only as a secure storage, but also as a creditor, the ways in which it may steal increase and become harder to detect. If the bank begins paying its bills with fraudulent receipts, it increases its own risk of failure as the number of customers wishing to withdraw their deposits may at any time exceed the amount of deposits it actually has. Therefore, direct payment of bills with fraudulent receipts is very risky.

If the bank does not make direct payment of receipts but rather loans out fraudulent receipts, when the loan is repaid, the bank will again be safe from failure due to inability to satisfy withdrawal demands, and will have earned profit in the form of the interest paid on the fraudulent loan. Similarly, the bank may make fraudulent deposit entries to customers’ accounts by not entering a withdrawal to its own account when giving loans. Once these fraudulent loans are repaid, the fraud will not be detected.

Note that a bank customer can engage in exactly this same fraud by writing checks against an account whose values sum to an amount greater than the amount deposited in the account they are drafted against. As long as the checks are themselves circulated as money (this used to be common) and not redeemed at the bank, the fraud can go undetected. The banking customer, in essence, becomes his own bank and can engage in his own fraudulent loans if he chooses. Let’s say Bob’s Grocery has a reputation for reliable payment of checks, so reliable in fact, that a $100 check from Bob’s Grocery is as good as a $100 bill. People may use checks from Bob’s Grocery in exchanges. Since many of his checks may not clear for a very long time, Bob realizes he can write more checks than money he has in his account. So, Bob begins to give $100 loans by writing $100 checks which circulate as money. Bob has, in fact, become a fraudulent banker.

The first kind of fraud – the printing of fraudulent receipts – is the original form of paper money inflation. I will call this printing-press inflation. It is nothing other than counterfeit. Using the same kind of procedure as with debasing coins, the government first declares a unit of paper money which is independent of any coin or other physical object or quantity. Then, it either bans all other forms of money or requires taxes to be paid with the official paper money and uses the same process the king used to debase coins to convert unofficial money into official paper money. By continually printing more paper money, the government can surreptitiously steal from its citizens, avoiding the political problems associated with taxation.

Printing-press inflation is still a very direct and measurable form of inflation. It is not too difficult for an interested observer to figure out how fast the government is printing new paper money. This evidence makes it difficult for the government to deny responsibility for price increases, which even the financially unsophisticated public understand to be a surreptitious tax.

The most subtle form of fraud – the direct deposit of non-existent money to an individual’s account to satisfy a loan – is the latest form of debasement. This is how modern governments inflate. The government can do this by operating its own bank and forcing other banks to keep their deposits in this bank – the so-called “bank of banks” or “central bank.” The central bank is authorized by law to buy government debt with new money that it creates on its charter authority. I will call this checkbook inflation, as opposed to simple printing-press inflation.

This enables the government to print bonds instead of money. The bonds are only necessary to avoid the appearance of outright fraud. If the government simply authorized the deposit of new money into its accounts at the central bank, everyone would know this was no different than printing-press inflation, just on the accounting books instead of with paper receipts.

The bonds are the root source of the inflation. In essence, bonds are a new kind of printing-press inflation. The bonds are supposed to reflect a future intent to pay the debt from future tax revenues. Sometimes, this even happens but government debt usually just increases. When private individuals buy government bonds, an argument can be made that the purchases reflect a belief on the part of the private individuals that the government can collect the promised future taxes and pay out the bonds on maturity. But when the central bank buys bonds from its government, this is just a way to justify the printing of money by the central bank on the pretense that all this new money will be collected in taxes at some point in the future. This is an absurdity – it’s like the king claiming it is acceptable for him to mint an extra 10,000 coins by debasement this year because he will be collecting 10,000 extra coins in future taxes. The king’s subjects should hope that he will limit his pilfering to just the minting of the extra 10,000 coins by debasement and renege on his promises to tax them even more in the future!

One last puzzle piece is necessary before fully explaining the mechanism by which modern governments create money. The government allows banks to legally engage in checkbook fraud, but it regulates the extent to which they can commit fraud. This is called “fractional reserve banking.” Basically, the government allows a bank to use up to 90% of the amount of deposits it has on hand to make new loans. An honest bank would only loan its own money or money that it has been loaned by its depositors (in the form of time deposits or CDs), that is, capital that it has acquired to its own account through profits earned on interest from pas loans, and its own credit. The government allows a private bank to loan not only its own money, but up to 90% of the money which it has on deposit.

Now, when the government wants to buy something, it plays a financial shell-game using these tools of bonds, checkbook fraud and fractional reserves. Let’s say the government needs $9 billion to buy some new tanks or to bail out some “crucial” financial company. It might take steps that look like the following: 

1)      Print up $9 billion of bonds

2)      Have the central bank “loan” $1 billion to its commercial banks by simply adding $1 billion dollars of assets to their balance sheets and $1 billion dollars of liabilities to its own balance sheet

3)      Have the commercial banks make loans to one another with this new $1 billion of up to 90% of the new deposits – this creates the money multiplier which inflates the original $1 billion to as much as $10 billion

4)      Have the commercial banks buy the $9 billion in bonds from the government (the original $1 billion has to be held as required “reserves”)

The effect is the same as ordinary printing-press inflation – the government can buy things with money that didn’t exist before. The crucial difference is that, just as fraudulent banks long ago discovered, giving loans of fraudulent money on the books is much less risky than directly issuing fraudulent receipts because fraudulent receipts, once printed, never go out of existence and represent a continual threat of failure. In theory, once all the government bonds are repaid, the books would be balanced and the money supply would have returned to whatever its base value is.

This convoluted system serves two purposes. First, it appears that at no point has money been created – at most, new loans have been authorized by the central bank to its commercial banks, backed by the government’s promise to repay from future taxes. But this is actually where the money is created – from what reserves does the central bank buy the government’s bonds? It has no reserves of its own, so this original “loan” is just a simple fraud and is purely inflationary. Second, the amount of money at the point where money is being created is just 1/10th of the actual final amount of inflation. This is politically helpful in minimizing the extent of the government’s inflation.

By using the money multiplier, the commercial banks help the government cover its tracks. Inflation, as measured by the fresh money the central bank deposits into the accounts of the commercial banks, appears 1/10th as large as it actually is. In exchange, the government allows the commercial banks to earn interest on the 10x multiplication of money, which “spreads the wealth” – the government spends the principal, but the private banks get their cut in the form of the interest.

Whether the central bank is structured like the privately controlled Federal Reserve or on the model of the publicly owned European central banks makes no difference. It is ultimately the private banks who enable the government to cover its tracks with the help of the central bank. It is the fact that there are many private banks which helps the government cover its tracks – think of it like the tor network for money.

The national debt has been non-decreasing for at least the last 60 years and is growing at an exponential rate (in non-inflation adjusted terms). For every dollar which the Federal Reserve creates, there is potentially $10 of actual inflation which the government has generated.

Inflation is debasement is counterfeiting is fraud is theft. Whether it be diluting coins, printing reams of paper money, or playing accounting shell-games, it’s always the same deal. The fiat money system is a con game writ large. Unfortunately, with the power to print money at will comes the power to buy legitimacy because the movers and shakers of public opinion can be bought. Everyone has a price and when you own a legal money printing press, no price is too high. Most people – even most economists – believe that the central bank system is somehow legitimate. This can only be the result of a failure to think clearly about the nature of money and banking. Ironically, this is all an open secret. The Federal Reserve long ago published a description of exactly how it creates new money in a booklet entitled Modern Money Mechanics.

The government has ostensibly stopped the practice of simply printing new money. The reality is that the printing of money has just changed forms. Before, the government simply printed circulation money. Today, it prints bonds and then uses the central bank and the banking system to convert these bonds into circulation money. Either way, the government is continually increasing the amount of money which continually causes prices to increase, just as the king’s debasement did. If you believe the government uses this power legitimately, you are a very special person. Most people understand that debasement and printing-press inflation are fraudulent and destructive to the economy. The key, today, is helping people understand that what the government is doing through the central bank is logically equivalent to debasing coins or printing new paper money. If it really is useful to inflate the currency, why the complex acrobatics to conceal the extent to which inflation is occurring?

My sources are Rothbard’s What has Government Done to Our Money?, The Mystery of Banking and Gary North’s Mises on Money. All of these are freely available online, and I highly recommend you read them. There are many videos available on YouTube which attempt to address the root problem of the modern central banking system – most notably Zeitgeist and Paul Grignon’s Money as Debt. While these videos are correct in sensing that the central bank is inflationary and is the root of the problem, they also contain factual or technical errors and propose solutions that are as bad, or worse, than the current system. When you have read Rothbard, Mises and North on the nature of money and banking, you will understand that our money should not be trusted to the government or its central bank. No individual or organization should be trusted with a monopoly on the issue of money. This is the closest thing on Earth to absolute power and the absolute corruption of the modern inflationary system is evidence of this.

We must end the Fed.

No comments: