Last week’s commentary resulted in a flood of emails, as has almost every commentary in which I mention that inflation is defined as the increase in money supply. So I thought I would devote another commentary to the issue since I believe it is important for all of us to clearly understand the nature of money, inflation and prices.

Inflation is the increase in the amount of money. If the supply of money increases (inflation) then the value of all the existing money declines by a proportional amount: a 10% increase in money supply causes a 9% decline in the value of the money.*

A very common misconception is that we have to adjust the value of money by changes in production of goods and services. That would only be true if we wanted to theoretically account for price changes: we would have to account not only for the increase in the supply of money but also for any increase (or decrease) in the production of goods and services. But that is not relevant to inflation and the devaluation of money; it is only relevant to prices.

In a hypothetical situation of monetary inflation with no change in the production of goods and services, prices would increase in direct proportion to the inflation rate: a 10% increase in the supply of money would cause a 10% increase in prices for all goods and services.

Similarly, if there was no inflation but the production of all goods and services increased by 10% then all prices would fall by 9%.**

There is no reason for inflation and the resulting increases in prices -- inflation is entirely an artifact of fiat money. Prices for goods and services should rise if demand for these goods and services rose faster than supply, and prices should fall if supply due to productivity enhancements rose faster than demand or if demand slows down.

The bottom line is that a 10% increase in money supply causes a 9% devaluation of your money. If you think that increases in production (as measured by the increase in gross domestic product for example) need to be subtracted from the increase in money supply to calculate inflation you are deceived. By subtracting GDP from the rate of inflation you may get a better handle on what average prices might do, but you miss the point altogether. Without inflation prices would fall due to productivity gains. With inflation prices fall less, or rise. To state that you have to subtract GDP from the increase in money supply to calculate inflation suggests a lack of understanding what inflation is by definition.

The real swindle is achieved by convincing people that real interest rates can be calculated by looking at changes in prices versus interest rates. Real interest rates should be calculated by subtracting monetary inflation (as calculated by M3, for example) from interest rates. If you did, you would find that real interest rates are negative. Bondholders do gain a small percentage if interest rates are higher than the average increase in prices but without monetary inflation they would have a much larger gain. The only reason they don’t is because government confiscates that benefit through inflation.

By inflating the money supply faster than increases in the production of goods and services the government forces prices to increase every year. In an earlier article called “Why the wealth gap keeps growing” I tried to convey the insidious nature of monetary inflation and how it robs the quality of life of most people, except those who know how to protect against it and have the means to do so. There is no reason for prices to rise other than the fact that governments can buy votes by spending money they don’t have and profit from seigniorage.

Seigniorage refers to the difference between the cost of producing money and its face value. I don’t know how much it costs to print a one-dollar bill but, assuming it costs five cents, then the Treasury makes $0.95 for every dollar bill printed. Following the benefits of seigniorage from the Bureau of Engraving and Printing (a department of the US Treasury) through the Federal Reserve Bank and back to the Treasury is a complicated matter but ultimately the benefit (supposedly) accrues to the Treasury and therefore, by extension, to the government.

In contrast, under a gold standard the government is hampered in its efforts to create money since it cannot create gold. The money of the country has to be earned by producing goods and services. If the government claims a monopoly on the issuance of money (which they usually do) then it can still profit from seigniorage but it will be a much more modest profit since it will have to buy gold at market price, mint coins and charge only a small seigniorage mark-up to prevent the coins from being over priced. When money has no inherent value and is instead just printed pieces of paper then the seigniorage is almost equal to the face value of the notes. How much do you think it costs to print a hundred dollar bill?

Furthermore, the income from seigniorage increases as the money supply increases since inflation increases the prices of goods and services and forces us to carry more money around thereby increasing the amount of money printed. It is therefore in the government’s interest to create inflation.

Some may argue that the benefit of seigniorage is ultimately returned to the people through government spending, and that may be true, but it amounts to nothing more than a distribution of wealth and hampers true economic growth just as all forms of wealth distribution do.

Again, if there were no monetary inflation then everybody would benefit from increases in productivity that would lower the prices of goods and services. It is just that we have become so accustomed to living with inflation that most people forget it is an artifact of government issued fiat money that exists only by virtue of the laws that force us to pay taxes in what would otherwise be a totally worthless currency. If Americans were not forced by law to pay taxes in US dollars, or if they did not have to pay taxes at all, the US dollar would be worth exactly the paper it is printed on.

Another common misconception about inflation is the idea that it is necessary for the money supply to increase in proportion to the economy: the “You cannot run a trillion dollar economy on a billion dollars” argument. That is ludicrous. Were it not for monetary inflation it would not be a trillion dollar economy in the first place.

The reason why gold’s value is so stable over long periods of time is that the inflation rate of gold, defined as mine production relative to all previously mined gold, is about the same as worldwide increases in population, and population growth is roughly in line with increases in the production of goods and services. Every now and then we undergo a period of dramatic productivity enhancements such as the industrial revolution but such periods are few and far between and have a minor impact on average production over long periods of time.

In essence, if monetary inflation was kept at exactly the same rate as population growth, which is about the same as the increase in production, then prices would be stable and we would all be a whole lot better off. The wealth gap would not increase and people would be able to plan and save for retirement without the confiscation of their savings through the ravages of inflation.

If, on the other hand, we had no monetary inflation then prices would gradually fall and the unit of currency would get smaller. If gold were the only money its value would rise relative to goods and services as the population grew and output increased. Prices in terms of gold would fall and we would need ever-smaller amounts of gold for our daily transactions. There is nothing inherently wrong with this and it means that people who saved would get the full benefit of their savings as the purchasing power of their capital grew in proportion to the increase in goods and services. Now, wouldn’t that be nice?

*If 100 widgets cost $100 and the money supply is increased by 10% then, assuming no change in the supply of widgets, 100 widgets would cost $110 post inflation. Therefore, post inflation, you would only get 91 widgets for $100 and the decline in widgets that you could buy is 9%.

**If 100 widgets cost $100 and the supply of widgets increased to 110 then, assuming no monetary inflation, 110 widgets would cost $100. 100 widgets would now cost only $91 for a decline of 9% in the price of widgets.

Paul van Eeden

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