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Source link: http://archive.mises.org/8012/inflation-and-the-public-consciousness/

Inflation and the Public Consciousness

April 10, 2008 by

When central bankers blast central banks for being reckless, you know the problem is serious. Indeed, it seems that everyone suddenly really cares about inflation. Everywhere you go, this is the talk, at the grocery, the gas station, among your neighbors. Price increases have been persistent in major sectors such as medicine and education for decades, but today the trend is conspicuously hitting the stuff that people buy everyday. So the reminders are ubiquitous, and public anger is growing. FULL ARTICLE

{ 17 comments }

Mike Sproul April 11, 2008 at 10:23 am

The only measure of the money supply that has anything to do with inflation is the quantity of money issued by the Federal reserve (and the treasury, but that’s for another post). The dollars issued by the Fed are backed by the Fed’s assets, so if the Fed’s ratio of assets to liabilities falls, the Fed’s dollars will fall in value. Private banks can issue as many checking account dollars as they please without affecting the Fed’s assets or its liabilities, so checking account dollars have no effect on the value of the paper dollars issued by the Fed.

PS: The next time someone tries to tell me that “We all know what the real bills doctrine says about money.” I’ll refer them to this article.

fundamentalist April 11, 2008 at 1:25 pm

Mike: “The dollars issued by the Fed are backed by the Fed’s assets, so if the Fed’s ratio of assets to liabilities falls, the Fed’s dollars will fall in value.”

I thought the RBD said that couldn’t happen. The Feds issue new money in exchange for bonds or other assets. How do the Feds issue money without purchasing assets?

Mike: “Private banks can issue as many checking account dollars as they please without affecting the Fed’s assets or its liabilities, so checking account dollars have no effect on the value of the paper dollars issued by the Fed.”

So you’re saying the local banks can issue dollars just like the Feds, but that doesn’t effect the value of those dollars, even though Fed issued and local issued dollars all look alike to consumers? Besides, when local banks make loans, that effects the reserves they hold at the Fed bank and therefore affect the Fed’s balance sheet.

Don April 11, 2008 at 8:43 pm

The Fed has conveniently stopped publishing M3 data. According to John Williams, M3 growth has accelerated ever since and now annual M3 growth now surpasses its historic 1970′s high (now above 17%).

John Williams also provides alternate CPI, unemployment, and GDP statistics, see http://www.shadowstats.com/alternate_data

His last publicly available discussion showing M3 from 1970 through mid-2007 is here: http://www.shadowstats.com/article/122

He just recently had a CNN video interview about M3 here: http://money.cnn.com/video/#/video/news/2008/02/28/news.hunter.shadowstats.Feb28.cnnmoney

PS. The TMS link no longer works.

newson April 12, 2008 at 9:07 am

to mike sproul:
here’s another question for you. where the central bank takes on a scarce resources such as gold (over whose production it has no control) on its balance sheet to back its notes, i have no no problem.

but what about essentially unlimited resources like houses? i mean, houses could be built on every square inch of america if the banks were willing to lend. but surely with every new house built, the cost of the next construction is going to be higher (competition for materials and labour), and so the value of the mortgage will have to increase until the last house would be astronomically costly (along with its mortgage). the moment this cycle stops (marginal speculators fail, having counted on the cycle never ending), the central bank’s balance sheet, denominated in progressively more expensive houses, also collapses. by your logic, the currency must too. am i wrong here? this to me seems the primary danger of using non-scarce resources like t-bonds, houses, infrastructure etc as currency backing.

oh, and as a postscript to an earlier blog, no dog can ever die by its own volition on a choke leash. the choke-leash controls the dog by conditioning its behaviour. after a few goes at self-asphixiation, the feedback loop kicks in and the dog thinks twice before tugging. this was the analogy i was trying to make with the beauty of currency convertibility.

Mike Sproul April 12, 2008 at 12:24 pm

“if the Fed’s ratio of assets to liabilities falls, the Fed’s dollars will fall in value.”

I thought the RBD said that couldn’t happen. The Feds issue new money in exchange for bonds or other assets. How do the Feds issue money without purchasing assets? ”

The RBD says that it won’t happen as long as the Fed’s assets rise in step with its liabilities. But if the Fed issues 100 new dollars in exchange for a bond worth $99, then inflation will happen. Inflation can also happen if the Fed loses assets, or if it deliberately maintains (financial) convertibility at a rate lower than its assets can support.

“So you’re saying the local banks can issue dollars just like the Feds, but that doesn’t effect the value of those dollars, even though Fed issued and local issued dollars all look alike to consumers? Besides, when local banks make loans, that effects the reserves they hold at the Fed bank and therefore affect the Fed’s balance sheet.”

No; a paper dollar is issued by the Fed, and is the Fed’s liability. A checking account dollar is issued by a private bank, and is the private bank’s liability. I suppose they look alike to some consumers, in the same way that Ford stock looks like GM stock to some investors, but paper dollars appear on the liability side of the Fed’s balance sheet, while checking account dollars appear on the liability side of the private bank’s balance sheet. They are independent of each other.
Of course, when private banks make loans, they might hold more fed dollars as reserves, but the fed will necessarily hold an offsetting additional amount of assets, so the Fed’s assets will move, but only in step with its liabilities.

“where the central bank takes on a scarce resources such as gold (over whose production it has no control) on its balance sheet to back its notes, i have no no problem.

but what about essentially unlimited resources like houses? i mean, houses could be built on every square inch of america if the banks were willing to lend. but surely with every new house built, the cost of the next construction is going to be higher (competition for materials and labour), and so the value of the mortgage will have to increase until the last house would be astronomically costly (along with its mortgage).”

By that reasoning, the Fed could lend money to gold miners and create the same self-perpetuating instability as they borrow more money, dig more gold, borrow against the gold, etc. One way to answer is to refer to the Law of the Reflux: Once the economy is well-stocked with cash, people will borrow existing cash, and banks will not be asked to lend newly-created cash. Another answer is that as long as each new $100,000 is backed by a $100,000 house, the self-perpetuating inflationary cycle you spoke of will never get off the ground, because all dollars are adequately backed.

newson April 12, 2008 at 10:04 pm

mike sproul says:
“By that reasoning, the Fed could lend money to gold miners and create the same self-perpetuating instability as they borrow more money, dig more gold, borrow against the gold, etc.”

but the difference is that building houses doesn’t present insuperable barriers. adequate funding will see a corresponding rise in supply of finished houses. there is no guarantee that a gigantic rise in funding to miners will see a corresponding rise in gold production. the physical barriers to production are much more formidable. it doesn’t matter how much money the bank throws at mining, as long as they can’t produce gold at a good clip, the price won’t be significantly affected.

“Another answer is that as long as each new $100,000 is backed by a $100,000 house, the self-perpetuating inflationary cycle you spoke of will never get off the ground, because all dollars are adequately backed.”

but we keep returning to the central issue of the value of the $100 000 house. what i’m saying is that the fed’s very actions intervening in this market inform the price of the asset. by vastly increasing the supply of houses in our example, the fed has become the market. in the case of gold, the central bank hasn’t been able to become a big player, with respect to existing stocks, because they can’t find enough of the stuff, regardless of the money they throw at it.

fundamentalist April 13, 2008 at 2:26 pm

newson: “but we keep returning to the central issue of the value of the $100 000 house. what i’m saying is that the fed’s very actions intervening in this market inform the price of the asset. by vastly increasing the supply of houses in our example, the fed has become the market.”

That’s true. Let’s assume for the sake of arguement that currency retains the value of its backing as RBD suggests, in this case houses. Then as the supply of houses outpaces the demand, the price of houses will fall. The $100k house might sell for say $50,000. Then the currency issued against those houses are worth less than the ones issued on the $100k houses. But as you pointed out above, the dollars backed by the $100k house are indistiguishable from those backed by the $50k house. One will determine the value of both dollars, but which one? The $50k house, because it was the last one sold. This is another example in which the RBD completely ignores an irrefutable economic principle, marginal theory, which is over a century old. The price of all commodities takes on the price of the last one sold, regardless of what its value was previously. So even if part of the RBD were true, marginal theory forces the value of newly issued currency to fall at the rate of the assets backing it.

P.M.Lawrence April 14, 2008 at 3:49 am

Ah… fundamentalist, the value of the total pool they hold isn’t the (final) marginal price multiplied by the number of units, precisely because the effect would operate in reverse as they liquidated their holdings – even if they did it slowly enough to avoid distress sale prices – and it’s that liquidation value that best represents the “true” value. You have to estimate how the marginal price would fall, which means making some assumptions. For small pools, the marginal price multiplied by the number of units is a good working approximation because the effect is small enough that you could assume approximately no fall, but that’s not a workable assumption here.

An ant can assume a trampoline is a solid surface; a man can’t.

fundamentalist April 14, 2008 at 8:04 am

P.M.: “You have to estimate how the marginal price would fall, which means making some assumptions. ”

I’m not sure what you’re saying. Are you saying that the value of dollars back by houses would anticipate the future lowers value of dollars as people expected the price of houses to continue to fall?

Mike Sproul April 14, 2008 at 10:58 am

Newson:

The supply curve slopes up for both houses and gold, and in both cases the existing stock is large relative to new supply. You also have to remember that a loan makes a house only marginally more affordable to the borrower. It’s not a case of the loan suddenly making a house free, where before it had been unaffordable.
You can read my “Three False Critiques” paper for my answer to what I call the “Money’s Worth” fallacy of Lloyd Mints. He made an argument similar to yours: that people borrow new money and post goods as collateral, but that the new money causes inflation and increases the value of the collateralizing goods, which allows the people to borrow still more, etc. The problem with the argument is that issuing money on adequate collateral does not cause inflation, so that this self-perpetuating cycle never gets off the ground.
Just some general principles: I think we agree that
(1) new money issued in exchange for one ounce of gold is not inflationary
(2) New money issued in exchange for nothing is inflationary.
but when we come to (3) New money issued in exchange for goods worth one ounce of gold is not inflationary, then you disagree, even though the bank that issued the money can use its assets to buy back all the money it has issued. Austrians make a huge mistake when they say that case (3) is the same as case (2).

newson April 14, 2008 at 11:01 am

mike sproul says:
“By that reasoning, the Fed could lend money to gold miners and create the same self-perpetuating instability as they borrow more money, dig more gold, borrow against the gold, etc.”

imagine the fed doubles the housing stock of the us – houses would collapse in value, taking the dollar down with it. on the other hand if the fed lends to gold miners. they are only going to operate up to breakeven, after which the gold is cheaper to purchase on the open market. doubling us mining company expenditure wouldn’t have a enormous effect on world gold prices. all the easy surface gold has already been tapped in investor-friendly territories, and only with very advanced geological tools can discovery proceed apace. elsewhere, sovereign risk is the bar to mining. the value of the gold on the fed’s balance sheet doesn’t seem likely to be greatly affected by its getting into the gold-mining business, and so the dollar is also safe.

fundamentalist April 14, 2008 at 12:29 pm

newson: “if the fed lends to gold miners. they are only going to operate up to breakeven, after which the gold is cheaper to purchase on the open market.”

Excellent point! That’s why gold has been used as money longer than anything else. The first money was cattle and wheat. But people figured out really quickly that the supply of each can increase dramatcally and cause their value to fall. Some have argued for using land as the limiting factor for money creation, and they’re right that land is scarce and limited. Once all of the land in the country had been monetized, inflation would stop. But getting to that point would take a very very long time and the increase in inflation would be dramatic until we reached that point because the land doesn’t require the expensive of mining. It already exists in a useable form. All that needs to be done is for the bank to issue loans with land as collateral. If we wanted to, we could monetize all of the land in the US within a few weeks.

On the other hand, it’s very expensive to add to the current stock of gold, so monetizing all of the gold that exists on the planet is a very slow process. The gold supply increases just 2-3% per year. The supply of land avaible for monetizing can increase hundreds of percent per day until we have monetized all land available.

newson April 15, 2008 at 3:32 am

mike sproul says:
“I think we agree that
(1) new money issued in exchange for one ounce of gold is not inflationary
(2) New money issued in exchange for nothing is inflationary.
but when we come to (3) New money issued in exchange for goods worth one ounce of gold is not inflationary, then you disagree, even though the bank that issued the money can use its assets to buy back all the money it has issued. Austrians make a huge mistake when they say that case (3) is the same as case (2).”

as you rightly say, we part company at (3). and the reason is simply that in selling houses to buy back its gold, the fed would collapse the house market. perhaps it’s the way i’m expressing myself, but whilst houses are a asset of value, their are no almost no obstacles to increasing supply. if the fed were to sell gold, it would be absorbed across the global market, were it to sell houses, the pool of potential buyers is confined to us investors. there is no guarantee it would recoup.

Mike Sproul April 15, 2008 at 10:42 am

Newson:
“in selling houses to buy back its gold, the fed would collapse the house market.”

So let the Fed issue dollars in exchange for miscellaneous assets. Better yet, let the fed issue dollars for bonds. If the Fed sees a need to buy back those dollars, the Fed can sell those bonds directly for paper dollars, thus soaking up the excess dollars without putting any pressure on the market for any one good.

newson April 15, 2008 at 11:28 pm

mike sproul says:
“So let the Fed issue dollars in exchange for miscellaneous assets. Better yet, let the fed issue dollars for bonds. If the Fed sees a need to buy back those dollars, the Fed can sell those bonds directly for paper dollars, thus soaking up the excess dollars without putting any pressure on the market for any one good.

i think that pretty well describes the situation today. the demand for t-bonds has been given a huge lift by the asian central banks pursuing their cheap currency mercantilism. it’s impossible to say how long negative real yields can persist for treasuries; good politics can mask bad economics in the short run, but ultimately economic reality re-asserts itself. i would be looking for much higher yields on longer treasuries in the next years.

newson April 16, 2008 at 2:35 am

ps to mike sproul:
“miscellaneous assets” pretty well sums up what the fed going to be buying in the very near future anyway. it’s not hard to imagine that some of the paper that the fed buys will include some of the exotic synthetic instruments the banks have cooked up over the last decade (backed by aircraft leases, credit card payments etc). the value of this paper, however, is dubious, hence the fed’s frenetic attempts to save bear stearns, that it’s derivatives be spared market valuation.
the emperor’s clothes are just fine, thank you very much!

filc June 2, 2009 at 7:07 pm

Paper money backed by Bonds is inflationary and the normal rules of RBD do not apply since scarcity of the currency never comes into play.

The whole argument that RBD rules apply when using bonds perverts the fundamental argument of RBD.

Money backed by bonds is completely inflationary. Bonds are not hard assets.

Explain to me again Mike Sproul what happened to Zimbabwe’s dollar currency? The federal Reserve Bank of Zimbabwe follows the exact same practice as our central bank. You claim it’s not inflationary yet their paper money isn’t worth wiping your butt with!

Thanks again

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