Please provide any criticism/input on the following text. I’m planning to put together a new “What is Inflation?” video for YouTube, probably in two parts. I would like it to be narrated (hopefully Graham Wright’s offer to narrate a video is still open) and I will put the slides together after I get some input on the text below:
What is Inflation?
Over time, money becomes less valuable. This is the ordinary state of affairs in modern life for almost everyone in the world today. But why does money become less valuable? Has it always been this way? Does it matter?
Since inflation is about money, we will spend a little time talking about money. Many people feel that money is complicated. People might feel this way because modern money systems use decimal arithmetic including long division, exponentiation, roots, logarithms and other advanced arithmetic concepts that we may have forgotten about since we graduated secondary school. People might also feel this way because financial services and products use a dizzying array of obscure jargon and concepts that can be intimidating to non-specialists.
But the essence of money is simple.
Imagine a world with no money. It is still possible to buy and sell things. Let’s say you have a couch and I have a television. Let’s say you need a television and I need a couch. We are very lucky to know each other and happen to want something that the other person has and each value what the other person has more than we value what we have. But how often does it work out that the person you want to buy from happens to want precisely something you have? This is called direct exchange or barter.
Instead of exchanging my television directly for a couch, I could have exchanged my television for some jewelry. Jewelry is more marketable than televisions, so I am more likely to find someone who has a couch and wants jewelry than I would have been to find someone who has a couch and wants a televisions. This is called indirect exchange and this is the process by which a good comes to be money.
The value of money is not always the same. There is an urban myth that the value of a gold coin is about the same today as it always has been. This is not true and there is no reason it should be true. The value of gold coins - when gold coins were used as money - fluctuated just as the value of all other goods and services constantly fluctuate in the market. In fact, this was the cause of the serious problems caused by “bi-metalist” policies that attempted to fix the prices of gold and silver relative to one another during the 19th century.
We should briefly review the concepts of supply and demand before continuing.
- When the supply of a good decreases, the price of that good rises
- When the supply increases, the price falls
- When the demand for a good decreases, the price of that good falls
- When the demand increases, the price rises
And not only do supply and demand drive the price but price also drives supply and demand.
- When the price of a good rises, supply increases while demand decreases
- When the price of a good falls, supply decreases while demand increases
Like all other goods, money has a supply and a demand. The supply of money in a gold and silver coin economy - such as that which existed in 19th century Europe and America - is the result of the industries that mine gold and silver and mint and assay coins and bars - industries that are usually regulated or completely monopolized by the national government.
The demand for money is slightly more subtle. It can also be called the demand for cash balances. If people become generally more disposed to save, the amount of goods and services which must be offered to tempt them to spend their money must increase. In other words, prices must go down.
A general fall in prices is evidence of either:
- An increase in the demand for money
- A decrease in the supply of money
… or both.
A general rise in prices is evidence of either:
- A decrease in the demand for money
- An increase in the supply of money
… or both.
Natural decreases in the value of money is called “inflation” by modern economists and a corresponding increase in the value of money is called “deflation.” This is a confusing terminology so don’t feel intimidated by it.
But natural fluctuations in the value of money are not the sole cause of changes in the value of money. Kings frequently engaged in debasement of their coinage. Debasement is a dilution of the precious metal in a coin with a base metal, permitting a larger number of coins to be minted with the same amount of precious metal. By adding 10% of copper to the gold coins he mints, the King can mint an extra 10% of coins, boosting his wealth and purchasing power. Kings debased their coins at very subtle rates because markets were extremely sensitive to coin debasement so it was crucial to make it very hard to detect how debased a coin was.
As time passes, the debasement will cause a general decrease in the value of coins due to a principle called Gresham’s Law - people will tend to hold onto the non-debased coins and use the debased coins to buy things. The non-debased coins are more valuable when melted down and sold for their precious metal content. This happens even today when the metals used in coins become more valuable than the face value of the coins themselves. Some individuals will buy up those coins, melt them down and sell the metal for its going bullion price.
However, the artificial effect on prices of coin debasement is very gradual compared to the general rise in prices which we experience today. If you follow the US government’s official Consumer Price Index statistics - which likely understates the actual decrease in the value of US dollars over time - there was 582% cumulative inflation from 1970 to 2011 and there has been 2,280% cumulative inflation from 1913 to 2011.
There are many theoretical problems with comparing absolute changes in the purchasing power of money over long periods of time. Depending on your assumptions, you can derive absurdly exaggerated or absurdly understated rates of depreciation. However, the one thing that remains the same in any consistent measure of inflation is that, with brief and minor exceptions, money is constantly becoming exponentially less valuable over time, at a non-negligible rate.
What is responsible for the much more rapid rate of depreciation today than happened under coin debasement by kings? In the modern world, we have banks and banknotes and this has created two innovations in the art of debasement. Banknotes were originally receipts for gold or silver coins deposited with a bank. If a bank issued more banknotes than gold or silver coins it had to cover those banknotes, it could experience a bank run or panic as depositors rushed to redeem their notes before there were no coins left. Such bank runs could result in bankruptcy of the bank if had been engaging in inflationary banknote issue.
Unlike a private bank, the government has the power to make up losses through taxation. By operating its own bank, a government can issue a larger number of banknotes than the gold or silver coins backing its banknotes. If a run begins, the government can tell people to go home and stop worrying because it will buy up the additional gold and silver coins with tax revenues. However, governments can push it too far and end up hyper-inflating their currency, as happened to the Weimar Republic in post-World War One Germany, the Continental Congress of America or the French Banque Generale during the bursting of the Mississippi Company bubble. In hyper-inflation, the government’s banknotes become worthless slips of paper.
But a bank does not have to issue banknotes for gold and silver coins it takes on deposit if the depositor has an account with the bank. Instead, the bank can simply make an entry in the customer’s account to the effect that such-and-such number of coins were deposited on such-and-such date. Then, the customer can later come and withdraw these coins. In the meantime, the bank is able to loan out these coins to other customers. In order to increase its profits, the bank might be tempted to simply fund loans with fictitious coins… that is, it may simply credit such-and-such number of coins to a customer without deducting those coins from some other account. In this case, the bank is doing precisely the same thing as if it had issued more banknotes than it has coins on hand but without actually issuing banknotes. The bank also runs the same risk that its customers could begin to suspect that they are engaging in this practice (also called “fractional reserves”) and a banking panic may ensue with the same consequences as for a bank run due to excessive issue of banknotes.
In a more sophisticated form, this is the manner in which modern central banks inflate the money supply. The modern central bank issues very little new physical currency. Instead, most of the currency is created through a complex process of bond purchases and inter-bank loans. However, the mechanism by which the supply of money is increased is irrelevant to the point that the supply of money is being increased.
We cannot automatically blame all of the decrease in the value of money on central banks and government’s increase of the money supply. There is always in operation a natural fluctuation in the value of money. However, there is no necessary reason why money should constantly become less valuable so the long-term, general, exponential decrease in the value of money must be the result of artificial causes, that is, of government and central bank action.
A question that may remain in the minds of some is why does the government increase the money supply? If you asked the chairman of the Federal Reserve, he would say that the government does so in order to “maintain full employment”. He would be referring to a very sophisticated argument which goes back to the economist John Maynard Keynes that attempts to establish a correlation between inflation and employment. In other words, by “printing money”, the Federal Reserve is supposedly giving people jobs during times when there is under-employment.
This is a very complex issue which we will not attempt to address here. Rather, let’s ask a simpler question: why did kings debase their coins? Do you think that kings debased their coins in order to maintain full employment, hundreds of years before John Maynard Keynes and other economists would construct a highly complex theory in order to explain why they thought this was possible? Is there a more direct motivation for debasing coins? In fact, there is. By debasing coins, the King can spend more than he collects in tax revenues. Since taxation is always unpopular, this can help the King spend more than the public would be willing to bear if directly collected in the form of taxes.
But who does it hurt? Isn’t the King creating more money, thereby actually enriching everyone? This line of reasoning is called the fallacy of composition, that is, a fallacy that assumes that the whole is like its parts. Your tongue is part of you but it is not you. It is a mistake to think that the things that are true of your tongue are therefore true of you, as a whole. It is true that when an individual in the economy gets more money, he has become richer. However, it is not true that by increasing the money of all individuals in the economy (through debasing coins, printing money, or expanding credit) that all individuals in the economy become richer. Even those economists who argue in favor of inflation do not argue that inflation actually makes all of us richer.
It is as true for democratic governments as it was for kings that inflation permits the government to spend more money than it could hope to collect through direct taxation, even though the government would not like to admit that this is a motive for inflating. The question of whether it helps maintain full employment is a technical question to be resolved by academic economists but everybody can understand that the government has a direct interest in inflating irrespective of positive benefits it may or may not have for society.
So what can we do about it? Some people are calling for an end to central banking: End the Fed. Ending the Federal Reserve would be a positive step in forcing the government to be accountable to the public for the full costs of its domestic programs and foreign policy adventures. However, shuttering the Federal Reserve overnight would certainly lead to financial and economic chaos because there are no other institutions which can perform its necessary functions in the economy. Proponents of central banking sometimes caricature the call to end the practice of central banking as if this is what is being called for. Rather than lobbying to shutter the Federal Reserve overnight, we are proposing liberalization of currency issue. That is, we should compel the government to stop prohibiting competition in the issue of money. Private banks should be free to issue their own banknotes. Private mints should be free to issue their own coins. We should allow the market to select from among these alternatives those which best suit the needs and requirements of industry and consumers. In the meantime, the Federal Reserve can go on issuing its own notes and regulating its own member banks. Faced with competition from the private sector, however, the Federal Reserve would no longer be able to compel industry and consumers to patronize its banknotes and its member banks. Because competitive pressures would drive money producers to produce non-inflationary money, the government would eventually completely lose the ability to inflate at all. The Federal Reserve would have to either comply with the best practices of the money production industry or face its own demise. This is the best course of action for the well-being of Americans.