What's Your CPI? Economic textbooks would lead you to believe that economists can measure inflation by calculating the overall price change in a "market basket" of goods and services. However, if you were to look at these goods and services individually, you would find a great variance in price changes. For example, in the past decade, the price of automobiles, houses, movies, and health care has increased significantly. However, the price of computers, DVD players and big screen TVs has actually fallen. To profit from inflation, you must understand that the inflation rate can be very misleading.
There are many different measures of inflation, but the one you are probably most familiar with is the consumer price index. As you learned earlier, to calculate the CPI, government economists use a market basket of goods and services, which represent many of the goods and services that we consume frequently. Items such as housing, food, transportation, communication, etc. are represented by specific goods whose price changes can be accurately recorded over time. Economists then weight the items in the basket as to their relative importance. For example, they weight the price of gasoline more heavily than the price of tomatoes since we spend a greater percentage of our budget on gasoline. Once they record the cost of the individual items and assign their respective weights, they can calculate the CPI. The economists compare that number to last year's number to determine the inflation rate as measured by the CPI.
The basket of goods that the Bureau of Labor Statistics uses to make its calculations contains some 211 goods and services. Each month, the Bureau’s agents go on a simulated shopping trip, during which they tabulate the price of these items. However, the Bureau changes the contents of the basket only about every ten years. One might therefore argue that the CPI could be outdated and may not accurately reflect changing consumer spending patterns. For example, the average person today will likely spend a greater portion of his income on items such as cell phone bills and high-speed Internet access than he did ten years ago, and those items should receive a higher weighting in the basket. The government revised the weightings in 2002.
Nevertheless, the consumer price index has not been relevant to my life. For example, I would question how many of those 211 goods and services in their basket I actually use. In fact, I would argue that I do not use some of them at all, and that others I use far more than the average person does. One of the items in the basket is college tuition. What if you are single, childless or your children are grown? Your weighting in the basket should be zero. Suppose you have three kids in college. Who knows what your weighting should be?
The market basket includes housing as one item, but it has no way to differentiate among localities. Most importantly, it takes the cost of renting, not of buying. How practical is that? Consider the variability of clothing costs. On average, women spend more of their incomes on clothing than men do, but the CPI fails to account for gender differences. Younger people spend a greater percentage of their incomes on car insurance, while older people spend more on pharmaceuticals.
I would conclude that each one of us has a completely different basket with completely different weightings. If that is the case, you have your own inflation rate.If you receive annual salary increases of five percent a year and the government tells you that inflation is only three percent, you might think that you are getting ahead, but you could be dead wrong. Think about all the things that you spend money on, and then decide what your own inflation rate is. Chances are it will not be anything like the CPI.
Although the CPI is the most widely recognized measure of inflation, two other inflation measures are worth watching. The first is the PPI, which stands for Producer Price Index. The PPI measures the average price level of goods sold by producers to wholesalers. It is important to watch the PPI because it is a leading indicator of the CPI. When price increases occur at the producer level, producers generally pass on their price increases to wholesalers. The wholesale price index (WPI) measures the average price level of goods sold by wholesalers to retailers. To review, price increases in the economy show up first in the PPI. The price increases then show up in the WPI, and finally directly affect the consumer once they reach the CPI.
Pushing and Pulling There are two main types of inflation: demand-pull inflation and cost-push inflation. These terms illustrate what causes the particular inflation that is occurring. Demand-pull inflation is sometimes referred to as cyclical inflation because it occurs during cyclical expansions – i.e. prosperous economic conditions. For example, consider the auto industry. When economic growth is strong, consumer income rises and the demand for automobiles is strong. Automobile companies can raise their prices because they know that the buying public want new cars and they will be able to afford them even if prices are slightly higher than before. The same phenomenon occurs throughout the economy, causing the increased demand for goods and services to pull inflation higher. Thus, purchases of final goods and services are the driving force behind demand-pull inflation.
Economists used to believe that cycles in our economy were the natural result of supply/demand pressures. In good times, the demand for products would exceed supply, causing manufacturers to raise their prices. During economic slowdowns, lack of demand would keep price increases in check. However, such simple models have nearly gone by the wayside, as have the economists, labeled Keynesians, who followed them. A new group, known as monetarists, has since come to the forefront. Monetarists believe that the supply of money in the economy is what really causes demand-pull inflation. In a few words, they believe that inflation occurs when too much money chases too few goods.
The monetarists certainly have recent history on their side. They claim that, if the Keynesian model still held true, we would expect to see inflation rise during cyclical expansions and fall during cyclical contractions. However, during three different periods in the 1960s and 1970s, inflation was actually higher during the contractions than during the expansions. Additionally, inflation rose even in the face of rising unemployment.
According to monetarists, what we really need to be concerned about is our money supply. There are three measures of money supply: M1, M2, and M3. M1 is the amount of money in coins, notes, and checking accounts. M2 adds in savings accounts. M3 is the broadest measure of money supply and includes not only currency in circulation but certain forms of debt as well. While the government tends to use M1 when referring to the money supply, inflation watchers keep their eye on M3. Starting in 1997, the money supply, as defined by M3, has increased dramatically every year. When too much money exists, the currency eventually begins to lose its purchasing power. If you have savings denominated in dollars, the value of your savings diminishes as the money supply increases. That is why we can justifiably think of inflation as a silent thief in the night that robs every one of us.
Cost-push inflationis the second type of inflation. The cause is an increase in the price of inputs used in production. Take our automobile example. With demand-pull inflation, the final price of the automobile was higher because public demand allowed the automobile companies to raise their prices. Now, consider this. The price of steel, a critical component used to build automobiles, suddenly increases by 20%. What must happen? The automobile companies face a choice. Either they raise the price of cars that they are building or their profit margins will shrink. I think you can guess what their choice will be. Thus, in cost-push inflation, the cost of inputs used in the production process pushes up inflation.
Many inputs can ignite cost-push inflation. Using our automobile example, dozens of inputs go into the production of an automobile. A price increase in any one of those could force manufacturers to increase the price of the final product. For example, mining strikes in South America could adversely affect the cost of copper. Demand for catalytic converters could cause a shortage of platinum. Higher oil prices could raise the price of plastics and vinyl.
The largest input contributing to the price of an automobile is not even a commodity. Can you think what it might be? The answer is labor. What happens when inflation hits other items in our market basket? For example, if the cost of college tuition, food, or pharmaceuticals were to show marked price increases, you would expect autoworkers to feel squeezed like everyone else. Most likely, they would soon demand higher wages to keep up with the increased cost of living. Subsequently, the auto manufacturers would pass the added labor costs on to the consumer in the form of higher sticker prices for new cars.
Can you see why you need to be aware of cost-push inflation? Like a wild fire in the forest, it can start in many different ways and quickly spread out of control. The primary source of this type of inflation finds its roots in commodities and natural resources, which are inputs to our products. Therefore, it is not surprising that commodities are often a good leading indicator of future price inflation. However, the price of commodities is not always a reliable indicator of future inflation. Sometimes commodity price increases are the result of short-lived supply problems. For example, a strike at a major copper mine could cause the price of copper to jump temporarily. Once the strike ended, however, production would return to normal. When you see the price of a particular commodity trending higher, ask yourself if it is because of sustainable cyclical demand. Staying with our copper example, copper prices could become inflationary if demand from China were the driving force behind higher prices.
Cost-push inflation, then, generally occurs because of
supply-side shocks. The magnitude of these shocks and their subsequent contribution to our overall inflation can vary greatly. The OPEC oil embargoes during the early and late 1970s was an example of supply side shock. The embargoes immediately caused a surge in the price of oil and other petroleum products. Higher oil prices caused energy prices to soar, which translated into much higher electricity prices. As the producers of goods and services saw their utility bills climb, the increased cost of production for energy dependent industries such as steel caused a ripple effect throughout the economy.
Without a doubt, cost-push inflation is both unpredictable and highly destructive. While demand-pull inflation may be considered the lesser of the two evils, in the final analysis, inflation is inflation. The two types of inflation are really just a way to describe how the inflation came about. One distinguishing factor between the two is that we have no control over cost-push inflation. When an American company is unable to control the supply of a needed, basic resource, it has to pay what the international market will bear for that product.
On the other hand, our government can control demand-pull inflation. The Federal Reserve controls the money supply. When our economy starts to slow down, the government increases the money supply to rev it up. When the economy is running well on its own, demand-pull inflation begins to show up and the Federal Reserve begins to tighten the money supply before inflation gets out of control. Economists call it fine-tuning the economy it works to a degree but is not an exact science.
The alternative to managing the economy through the manipulation of the money supply would be to let the economy follow a natural cycle based on supply and demand. Before the Federal Reserve became so intrusive in the economy, a four-year business cycle dominated the ups and downs of the economy. However, allowing the economy to follow natural business cycles is not politically popular. When a recession occurs, voters generally oust the current administration. Therefore, administrations historically do everything in their power to keep the country out of recession, especially in election years. To accomplish this, they attempt to orchestrate the economy by providing liquidity (adding money) to the system when a recession looms. If, instead, we are at a point in the cycle when the economy is starting to overheat--as evidenced by rising inflation--they will attempt to cool it off by reducing liquidity.
Inflationspeak We learned that the definition of inflation is an increase in the level of consumer prices. More accurately, inflation is an increase in the money supply beyond the available supply of what money buys. Here are some other related terms and concepts, which you should know.
Disinflation is defined as the gradual slowdown in the pace of price inflation. Thus, as inflation went from eleven percent in the 1970s to five percent in the 1980s, and then two percent in the 1990s, we experienced disinflation. Markets welcome disinflation. As inflation comes down, so do interest rates, which allow corporations and consumers to borrow money to buy and invest. Bonds become a good investment because investors hope to lock in a higher return today than they expect in the future. For example, investors might hope to lock in an eight percent return for the next ten years while the inflation rate declines in the future. That would assure them an income higher than the cost of living.
If disinflation gets out of hand, our declining inflation rate could turn into deflation. Deflation is the opposite of inflation, and occurs when the CPI goes into negative territory. The cause of deflation is a decrease in the money supply. When there is less money available to purchase the available goods and products, prices decline. With the high level of debt in our economy today, deflation would have disastrous effects. Loan defaults would produce a domino effect in our economy. Our government will do everything in its power to prevent deflation. Understanding that is the key to learning how to profit in the future.
Reflation is the term used to describe adding liquidity--i.e. increasing the money supply--to prevent deflation. When the economy has stalled or we are sliding into recession, the government always chooses to reflate, inflation being a lesser evil than recession. Stagflation occurs when, although the economy is in recession, inflation continues to creep higher. This is truly the worst of both worlds for both the economy and financial markets. There are no bright spots during stagflation. Stocks and bonds suffer, unemployment is high, and real estate prices are affected because of a combination of high mortgage rates and poor labor conditions. Stagflation, brought about by OPEC in 1973, characterized much of the 1970s decade. Stagflation is something that we need to watch out for in the future as it could have serious effects on our investments.
Hyperinflation occurs when inflation gets completely out of control. In the next chapter, you will learn how hyperinflations have destroyed economies in the past. The most well known hyperinflation occurred during the Weimar republic in Germany. Once the savings of the middle class evaporated, the disillusioned citizens--desperate for a solution--embraced the dictatorship of Adolph Hitler. Hyperinflation in the United States appears to be a remote possibility at this time. However, because the United States operates on a fiat currency, we should not rule out any future scenario.
Winners and Losers Inflation causes a redistribution of income and wealth within the economy, which would not otherwise have occurred. That could be a good thing for you or a bad thing, depending on where you are standing. After reading this book--and taking the appropriate courses of action--, I expect it will be a good thing. After all, you and I would like to see a redistribution of wealth right into our own pockets.
Since banks are central, not only to our economy, but to our own personal finances as well, we should examine how inflation affects banks. On a simplistic level, banks make money by borrowing--essentially from the government--at a low rate of interest and lending to consumers at a higher rate of interest. The difference is their profit. Future inflation is important for banks to gauge correctly in order to stay competitive and make a profit. For example, assume ABC National has borrowed money at three percent and will loan money to you at five percent for the next five years. If inflation unexpectedly rises sharply and their borrowing costs go to six percent next year, they will lose money on your loan. This example may be overly simplistic. In fact, the banking industry has evolved so that they can reduce their risks through markets in many sophisticated ways. However, it makes the point that unanticipated inflation can hurt bank profits. The plethora of adjustable rate mortgages is just one of the ways that banks have been able to protect themselves from unknown future risks of interest rate increases.
Inflation also affects labor. Most at risk are workers on fixed contracts. If a labor union makes a long-term agreement for salary increases based on the projected inflation rate, the real wage may actually decline if inflation increases. It is the same principle that we just saw with the bank. If a labor union has negotiated a contract over the next five years with wage increases of five percent per year, workers will be getting ahead if the inflation rate is three percent. However, if inflation doubles to six percent, their real wages (nominal wage – inflation rate) will actually fall.
Inflation creates uncertainty, which in turn adversely affects the entire economy. For example, if businessmen are uncertain about prices in the future, they are less likely to risk investing in long-term projects. A reduction in investment capital hurts the economy’s long-term growth. What about investors? With the value of paper currency declining, they are less likely to invest in stocks, and especially, bonds that would require payment in depreciated dollars. This lack of investment forces corporations and the government to pay higher rates of interest in order to attract capital.
In summary, inflation affects everyone: banks, corporations, business owners, investors, consumers, wage earners, and retirees. It weakens the entire economy and leads to higher interest rates, higher unemployment, and slower growth in the economy. Many of you reading this book may be too young to remember the high inflation in the mid-1970s. The seeds of that inflation were sown years earlier by government administrations that, in the late 1960s, turned the printing presses on full throttle in order to pay for the Vietnam War. Later, oil price shocks in 1973-1974 and 1979-1980 put the icing on the cake so to speak. What effect would that inflation have had on you as an investor during that period? Can you imagine a stock market that could not rally in 15 years (1966 – 1982)? How would your 401k and retirement plans have fared?
Fortunately, Mr. Volker and later Mr. Greenspan did a terrific job at the Federal Reserve in getting our country back on track. Their efforts to get inflation under control were rewarded by one of the longest periods of prosperity that the stock and bond markets have ever seen, but the pendulum may be about to swing back the other way. The very same factors that played havoc with our economy before are back again. The Iraq War cost a small fortune and we are still at the mercy of OPEC for our energy. After the stock market crash in 2000 (and beginning as early as 1997), the government embarked on a course of monetary expansion on a scale never seen before. So a demand-pull inflation in the near future is a given.
My real fear is that a cost-push inflation will occur as well. Remember, we have virtually no control over cost-push inflation. Finally—and we will discuss this phenomenon in more detail later—we are now facing major competition for our natural resources from industrializing countries such as China and India. Adding that element, what we could be facing might just be a "perfect storm" of inflation. Here is why: First, as stated earlier, there is no way we can avert demand-pull inflationary pressures brought about by large increases in the money supply. Second, we are at extreme risk for cost-push inflation, which could result from increasing energy prices. In addition, we are now in direct competition for critical natural resources from two emerging industrial giants: China and India. The demand for natural resources will raise the costs of our inputs of production, thus producing the same inflationary effect as cyclical demand would from within our own country.
The Puppeteers Every one has heard of the Federal Reserve, but if you were to walk up to people on the street and ask them to tell you about the Federal Reserve, you would get some vague answers. Given that the Federal Reserve and their policies have a greater effect on the economy than the President does, it would behoove each of us to understand as much as we can about this group. Remember, their predecessors single handedly caused the Great Depression by allowing the money supply to drop by one-third. Yes, indeed, we do need to keep our eye on those fellows.
The Federal Reserve is our central bank. You may have heard somewhere that the Federal Reserve is an autonomous body, acts on its own accord, and is independent of the whims of our politicians. That is only partly true. The Federal Reserve is run by the Board of Governors – seven members appointed by the President with the aid and advice of the Senate. The President appoints members to serve 14-year terms and chooses from among those seven members who will serve as Chairman and Vice Chairman for four year, renewable terms. The Federal Reserve is very much a branch of the government.
When we talk about the "Fed," we are usually referring to those seven men. However, we also have the Federal Reserve System, which is comprised of the Board of Governors, 12 Federal Reserve banks, and the Federal Open Market committee. These 12 banks, while federally chartered, are actually private corporations with stockholders, directors, and a President. The stockholders of each of these banks are "member banks" in its district. Think of the country as divided up into 12 sections with each section containing one Federal Reserve Bank. In each section there are hundreds of smaller member banks that each own a piece of the big Federal Reserve Bank. The Federal Reserve banks are located in Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
The Open Market Committee consists of 19 members – each of the presidents of the 12 Federal Reserve banks plus the 7 members of the Board of Governors. Only five of the bank presidents may vote at any one time so the Board of Governors always has the ultimate control of the committee. The FOMC holds eight regularly scheduled meetings a year, at which times they review economic conditions and adjust monetary policy in an effort to achieve their long run goals of price stability and sustainable economic growth. Monetary policy refers to those actions--such as influencing the availability and cost of money and credit--which they take to help achieve national economic goals.
Tools of the Trade The Federal Reserve has three tools at its disposal to affect monetary policy: open market operations, the discount rate, and reserve requirements. The Board of Governors is responsible for the discount rate and reserve requirements, and the Open Market Committee is responsible for open market operations. By using these three tools--which we examine in more detail shortly--the Federal Reserve influences the federal funds rate, which is the overnight rate that member banks charge each other for borrowing. Think of the federal funds rate as the inner circle when a stone drops into a pond. A change in this interest rate affects borrowing rates for longer-term maturities, which in turn affect credit in general and cause repercussions throughout the entire economy.
Of the three tools, open market operations are the most powerful. In these operations, the Federal Reserve either buys or sells U.S. Treasury securities or Federal Agency securities on the open market. Remember that a security is nothing more than an IOU. When the government needs money, it has only three ways to get it: 1) raise taxes, 2) print money, or 3) borrow money. When they choose to borrow money from the public, they do so by issuing a note or bond. You give them money and they promise to pay you interest plus the principal at maturity. That has the affect of taking money out of circulation. Therefore, when the Fed wants to tighten, it can issue IOUs in return for real money that you give them. Less money in circulation means lower inflation. When the economy is stalling, the Fed, via the OMC, can use its own money to buy back IOUs that are floating around on the open market. This operation puts money back into the system and acts like a tonic to the economy.
The second way the Fed can affect monetary policy is by adjusting reserve requirements. As you know, banks make money by charging a higher rate of interest for the loans they make than the interest they pay for deposits. If they were to maximize their profits, they would literally loan out every dollar that came in the door. Of course, that would not be prudent, so the Fed requires that all banks keep a portion of their deposits either in reserves deposited with one of the Federal Reserve banks or in cash in their vault. In this case, if the Fed wishes to tighten, it can require these banks to keep a larger percentage of their deposits in reserve. The fact that they cannot lend out as much to the public reduces credit availability, increases interest rates, and slows the economy. The opposite would occur if the Fed chose to loosen monetary policy in order to stimulate the economy.
The third and final way the Fed can affect monetary policy is by changing the discount rate, which is the interest rate charged by the Federal Reserve Banks on loans to their member banks. Increasing the discount rate has a domino effect, as the member banks must charge their borrowers a higher interest rate on loans. Those businesses must in turn pass on their increased borrowing costs in order to remain profitable. Once again, the effect of the Fed’s move is quickly felt throughout the economy. If the Fed wished to loosen monetary policy, it could do so by lowering the discount rate.
In summary, the Federal Reserve is a powerful body of men, and their actions and policy decisions can have a great effect on every corporation, small business, employee, and retiree in the country. By using the tools at their disposal (open market operations, reserve requirements, and discount rate) they can greatly influence the economy. As powerful as these tools are, however, they cannot guarantee us that our economy will hum along without missing a beat. In fact, nothing could be further from the truth. Not only are the Fed’s tools not omnipotent, if history is to be our guide, we cannot count on the Fed to do the right thing all the time. For example, read what Milton Friedman, who won the Nobel Prize in economics, had to say regarding the Fed’s decision-making:
"The exercise of this arbitrary power has sometimes been beneficial. However, in my view, it has more often been harmful. The Federal Reserve System, authorized by the Congress in 1913 and beginning operations in 1914, presided over the more than doubling of prices that occurred during and after World War I. Its overreaction produced the subsequent sharp depression of 1920-21. After a brief interval of relative stability in the 1920s, its actions significantly intensified and lengthened the great contraction of 1929-33. More recently, the Fed was responsible for the accelerating inflation of the 1970s – to cite just a few examples of how its powers have in fact been used."
At the beginning of this chapter, I stated that inflation causes a redistribution of wealth and income. Now I want to show you exactly how that works. Remember, inflation cannot exist without an increase in the money supply. Therefore, the Federal Reserve is responsible for all inflation. These days, our society operates not just on currency but also on credit. Money and credit are two sides of the same coin.
To give you an analogy of how inflation causes a redistribution of wealth and income, I want you to assume that you live on an island that uses gold for money. A fixed quantity of gold coins exists on the island and it is used as their medium of exchange. Then, one night, pirates come ashore with an equal amount of counterfeited gold coins. The pirates spend their counterfeit coins buying food and clothing, and purchasing homes. By bidding on those goods and properties, they have robbed all the islanders. With twice as much gold on the island, the price of everything eventually doubles. An islander who just borrowed from his father-in-law all the money to buy his island house is in good shape because his house is now worth twice as much. His brother, who had been saving for years to buy a house, is now further behind. Do you see how inflation steals from savers and benefits debtors?
The important point is that the counterfeiters were able to buy their island houses before prices doubled because they were the first to have access to the new money. Back in the United States, the first to receive the new money are the commercial banks, then those businesses who borrow the money, then the providers of equipment and resources that the businesses need, and on down the line. You can see that those at the top benefit most from inflation or the expansion of credit. Therefore, if you are still wondering why the rich get richer and the poor get poorer, that is part of the explanation. If you are at the tail end of the money machine, your money is shrinking just like the islanders who sat idly by while the pirates bid up the prices of their goods.
The Federal Reserve plays the same role as the pirates did on our fictional island. Here is how it works. Commercial banks are only required to keep approximately ten percent of their money on reserve the government allows them to lend the other ninety percent to customers of the bank. If the Federal Reserve decides that it wants to expand the money supply by $10 billion, it will purchase $1 billion of U.S. government securities on the open market (open market operations). The Fed then writes a check for $1 billion on itself, the Federal Bank of New York, and gives that check to a bond dealer who, in turn, deposits it into a commercial bank such as Chase Manhattan. Chase Manhattan then deposits the check back into its own account at the Fed's New York branch. With $1 billion officially in reserves, it can now loan out $9 billion. The total increase to the money stock is $10 billion. If the Fed wished to double the money supply, it could do so by lowering the reserve requirement from ten percent to five percent. Legally, it could lower it all the way to zero, giving it absolute power and control over the money supply.
Some feel that the Federal Reserve has created a house of cards. For much of the century, they have endorsed a policy of money creation to meet certain objectives, like financing government spending. When the government needs money beyond what it raises in taxes, it borrows it by selling government bonds. The Federal Reserve can buy those bonds simply by writing a check on their own account, in effect, creating money out of thin air. Apart from the commercial banking example, financing government borrowing also adds to the money supply.
How did we get to the point where our government can spend at will, and the Federal Reserve can create money and credit out of thin air? Paper money, backed by nothing more than government promises, is a rather recent monetary experiment. This experiment could one day be our undoing – at least that is what "gold bugs" believe.
Funny Money
For thousands of years civilizations used some form of commodity as a medium of exchange. In most civilizations, that commodity was either gold or silver. These precious metals worked as the perfect medium for exchange because people perceived them as valuable. Their value came from the fact that they were relatively scarce. Even when people found the metals, it took a great deal of human resources to either mine the metals or conquer neighboring lands to acquire them. Besides the perception of value, another benefit of using metals as money was the fact that, when reduced to coinage, metals were highly portable.
The use of gold and silver (bimetallism) as a medium of exchange was not always a perfect solution. As we will see in the next chapter, Rome encountered problems because they ran low on silver, while Spain got into trouble because they had too much of the metal. However, neither Rome nor Spain can put the blame entirely on the exchange medium itself. In Rome’s case, government spending was a contributing factor, while, in Spain, extravagance and fiscal mismanagement played a role.
The Chinese invented paper money during the reign of Hien Tsung (806-21). The paper money was suppose to act as a temporary substitute for the more traditional kind copper coins, which were in short supply as a result of a shortage of the metal. While the Chinese used paper notes sporadically from 960 onward, by 1020, China was awash with paper and the aftermath was not good. According to L.C. Goodridge, "A perfumed mixture of silk and paper was even resorted to, to give the money wider appeal, but to no avail inflation and depreciation followed to an extant rivaling conditions in Germany and Russia after the First World War." [ii]
The West did not learn of China's experiments with paper currency until some two centuries later, when Marco Polo--who had lived in China from 1275 to 1292--returned to the West and penned his famous Travels. Taken from a chapter entitled, "Of the Kind of Paper Money issued by the Grand Khan and Made to Pass Current throughout his Dominions," Marco Polo gives the following description:
"In this city of Kanbalu is the mint of the grand khan, who may truly be said to possess the secret of the alchemists, as he has the art of producing paper money . . . When ready for use, he has it cut into pieces of money of different sizes . . . The coinage of this paper money is authenticated with as much form and ceremony as if it were actually of pure gold or silver . . . and the act of counterfeiting it is punished as a capital offence. When thus coined in large quantities, this paper currency is circulated in every part of the grand Khan’s dominions nor dares any person, at the peril of his life, refuse to accept it in payment. All his subjects receive it without hesitation, because, wherever their business may call them, they can dispose of it again in the purchase of merchandise they may have occasion for such as pearls, jewels, gold or silver. With it, in short, every article may be procured. When any persons happen to be possessed of paper money which from long use has become damaged, they carry it to the mint, where, upon the payment of only three per cent, they may receive fresh notes in exchange. Should any be desirous of procuring gold or silver for the purposes of manufacture, such as drinking cups, girdles or other articles wrought of these metals, they in like manner apply at the mint, and for their paper obtain the bullion they require. All his majesty’s armies are paid with this currency, which is to them of the same value as if it were gold or silver. Upon these grounds, it may certainly be affirmed that the grand khan has a more extensive command of treasure than any other sovereign in the universe." [iii]
Fiat money (paper currency) did not come into wide use in Europe until approximately 1720, when John Law conceived a plan that led to the Mississippi Bubble. The resulting inflation left France in shambles for the rest of the century – hardly a testimony to the benefits of paper money.
Good as Gold
Despite various attempts at using paper currency in both the East and the West, all met a disastrous fate – it seemed to be only a matter of time. Eventually societies learned that--if they were to issue paper money for convenience--currency would have to be convertible to silver or gold in order to be trusted. Because of that belief, the "gold standard" came into being.
The gold standard saw its finest hour in the last half of the 19 th century. At that time, Britain was still the major center for finance. The British gold standard became the British Imperial Standard. By the last quarter of the 19 th century, it had become the International Gold Standard, and most of the trading nations of the world copied its success.
During World War I, governments needed additional money to buy armaments and finance the war effort. Thus, the major nations involved agreed to suspend the gold standard and print large quantities of money. After the war, most influential opinion in both America and England favored a return to the gold standard, but it was not to be. Instead, governments compromised by creating a "gold-exchange standard," whereby they committed to maintaining their ability to redeem their currencies in gold. World War II required the printing presses to roll again. However, after the war ended, only the United States had the ability to redeem its currency in gold, and then, only if requested to do so by a foreign nation. Under the Bretton Woods Agreement following World War II, the United States agreed to sell gold to foreign central banks at $35 an ounce.
In 1971, President Nixon broke the final link between the U.S. dollar and gold when he formally stated that the United States would no longer honor the Bretton Woods agreement. In popular jargon, he "closed the gold window." That date, August 15, 1971 lives on in infamy for gold bugs. (Gold bugs believe that our government should return to a gold standard.) Since that time, all the countries of the world have operated with fiat currencies – currencies that their governments have printed, as they have needed it, often without forethought as to future consequences. So far, the successes of these fiat currency schemes--in existence for only a tiny blip on a historical timeline--have achieved questionable success. Indeed, prices, interest rates, and exchange rates have fluctuated widely.
We must remember that for most of the world’s history, money based upon some commodity was the rule. The success of paper money systems has no historical precedent. In fact, Irving Fisher, one of the greatest economists this country has produced, had this to say about paper money: "Irredeemable paper money has almost invariably proved a curse to the country employing it." [iv] He wrote this in 1911 and look what we have seen since then. There were hyperinflations in most industrialized countries following World Wars I and II, and hyperinflations in South American countries long after that. In Japan, inflation reached 25 percent in 1973. The United States also experienced unacceptably high inflation in the mid-1970s – coincidentally, just a few years after leaving the gold-exchange standard.
The fact that all major countries have access to the printing press to solve whatever pressing problems confront the current administration is a frightening prospect to gold bugs. If, in fact, modern governments had worked out all the kinks of the fiat money approach to monetary policy, why have we suffered so many inflationary periods in such a short period?
Interestingly, inflations occurred in the ancient world prior to paper currency systems. However, those inflations took longer to take hold. For example, the great inflation that destroyed the Roman Empire was approximately 100 years in the making. The reason that inflations were slow in developing was that the world still operated on precious metals. In other words, there was still a commodity backing the currency (coinage).
Inflation occurred usually for one of two reasons. New discoveries of precious metals added to the money supply or the government purposely substituted less expensive metals in the mix (debasement). For example, copper was added to silver coins, reducing the amount of actual silver in a coin. In either case, it was a gradual process. The inflations of today and the hyperinflations we have witnessed could only occur with a system of fiat paper money. If we were still on the gold standard, those types of inflations could not occur.
Gold Bugs
In 1843, Edgar Allen Poe penned a story titled, "The Gold Bug." The gold bug (a beetle) bites the main character, who then embarks on a treasure hunt that eventually nets him a large cache of gold and precious jewels. Today, hard money advocates, sometimes called "gold bugs," believe that gold and silver are true wealth, and would like to see our currency linked to one or the other or both. They keep a large portion of their assets in precious metals, fearing that the dollar is bound to depreciate--if not become worthless--because of our politicians' bumbling or outright greed.
Gold bugs have been around since the 1970s. They hold conventions and publish newsletters. As investors, they have been obsessed with their belief that gold prices would rise dramatically and have suffered as a result. While precious metals and all commodities were in vogue and in bull markets in the 1970s, the next two decades witnessed bear markets and a return to financial instruments – both stocks and bonds. The gold bugs missed one of the greatest bull markets of the century in both stocks and bonds. As a result, their followers left in droves and the faithful are mostly those who have ulterior motives in fanning the flames – e.g. companies that sell gold and silver commemorative coins, brokerage firms that specialize in mining companies and newsletter writers who report on the industry and make recommendations.
Before dismissing the gold bugs out of hand, however, I should point out that there is growing evidence that we could be returning to a 1970s style financial environment, and that the conditions that we witnessed in the 1980s and 1990s--low inflation, low interest rates, and rising stock and bond prices--are a thing of the past. If so, gold bugs may get the last laugh. As to whether we will see the United States return to a gold standard, my personal opinion is that it is not likely to happen – unless, of course, we were to witness a catastrophic inflation.
A central question regarding monetary policy is whether we need to have our currency linked to some commodity standard or whether we can trust our politicians to manage our money supply wisely. There is no doubt that linking a currency to a commodity standard has proven to be the most effective way to ensure that governments do not resort to inflation as a source of revenue. However, that is not likely to happen any time soon. Should we be worried? There are equally valid arguments as to why we should not be.
When Fischer made his claim that irredeemable paper money was a curse, his experience was only up to that day. Certainly, our monetary policies have matured in the last century. But what about the post World War I and post World War II inflations? Granted, the number one cause of inflations is war. Regardless of whether you believe, as optimists do, that our present monetary systems are strong enough to eliminate inflation as a major problem in the future or you choose to side with the gold bugs, war is a wild card. If there were to be a major war, in which the U.S. played a major role, our politicians would have no choice but to resort to the printing press in order to finance the war. Later in the book, we will address the prospects for war in more detail.
Gold bugs might ask the optimists to explain the recent hyperinflations in Argentina, Bolivia, Brazil, Chile, and Mexico. We will discuss some of these inflations in more detail later. For now, it is enough to know that their economies were "Third World," their leaders were often corrupt, their debt was enormous, and their economies in no way resembled ours. I would have to side with the optimists on this one. So now that we have written off this century’s major hyperinflations in the industrialized countries as war related and the South American inflations as a product of Third World monetary ineptitudes, what is left for gold bugs to point their finger at? The answer is Japan. In the next chapter, you will learn how Japan's economy spiraled out of control and about the ensuing bust that eroded stock and property values and left the country in recession for more than a decade. Additionally, you will learn how money, credit, and inflation affect societies.
The Take Away
The CPI purports to measure inflation. However, in practical terms, it may be meaningless in our own lives. Each of us has our own CPI. Economists distinguish between two types of inflation: demand-pull inflation caused by excessive demand in the economy and cost-push inflation caused by supply-side shocks such as price increases in energy. Monetarists argue that the cause of inflation is always an increase in money supply.
We can measure the money supply in different ways, labeling the aggregates as M1, M2, or M3. M3 is the broadest measure and the most important to watch. During the past several years, M3 has increased dramatically, strongly increasing the chances of future inflation.
Inflation acts as a silent thief that robs the industrious–-those who have saved their money--while rewarding those in debt. Retirees on fixed incomes and other workers on fixed contracts are hurt the most by inflation. Unless you are in a business where you can control your pricing or your salary adjusts quickly to changes in the economy, you may find your purchasing power eroded by inflation.
The Federal Reserve has three tools to control the money supply, but the most important one is open market operations. In practice, they employ this tool to help the federal government finance its debt. When the government issues new debt, the Federal Reserve can buy that debt simply by issuing a check. The Federal Reserve then owns the security, and the money that they used to buy the security goes into the banking system. In this way, the government "monetizes" the federal debt. The government can also buy older debt on the open market. For every dollar that goes into the banking system because of the Fed's purchase, the banks can lend out ten dollars. The process, called "fractional banking," gives rise to a "multiplier effect" of the money deposited.
Using paper money, void of commodity backing, is a recent experiment in human history. There have been many instances of failure. The problem is always the same. Eventually governments spend more money than they have. Inevitably, this leads to currency debasement and the ruination of the society. The United States is on the same path. We must wonder if our country is doomed to repeat the same mistakes other societies have made throughout history. Further analysis brings us to question whether the system is flawed (Karl Marx, one of the most brilliant economic minds of all time, claimed that capitalism was doomed to eventually destroy itself), or the system fails because of the greed or ineptitude of those in power.
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Friedman, Milton , Money Mischief, p. 84.
[ii] Goodrich, L.C., A Short History of the Chinese People, p. 113 .
[iii] Dent, J. M., The Travels of Marco Polo, p. 231.
[iv] Fisher, I. The Purchasing Power of Money, p. 79.
