Okay, they’re really not. They are simply a logical progression of earlier concepts. You might want to review all the previous concepts, because a firm grasp on them will help during the next section.

Inflated egos

It is very common in today’s world to hear talk of inflation. For years we heard about inflation in the news, and we even have an entire government agency dedicated to fighting it–we hear how The Fed (Federal Reserve) raises and lowers interest rates to prevent inflation. If you asked your parents what inflation is, they probably told you how when they were young, they could buy a chocolate bar for a nickel or how gasoline used to cost 23 cents a gallon, and they used to drive around aimlessly all weekend. Then inflation struck in the 70s, caused gas shortages and long lines and general misery. You would probably have come away from the talk still not knowing what inflation was, but knowing it must be a terrible thing to have caused polyester, bell bottoms, and disco music.

In the last few months, inflation has fallen out of fashion, and the new bogey man is deflation. Because new anchors have as little knowledge of economics as most parents, they say that inflation is higher prices and usually cite one of two numbers, CPI and PPI, that are purported to measure inflation. But they don’t. The truth and history is much simpler…and more complicated. Murray Rothbard has a wonderfully short book dedicated to it called, What Has Government Done to Our Money?

Inflation is simply an increase in the money supply other than what would ordinarily be anticipated. Recall from earlier that money is simply a commodity that is valued more for its ability to facilitate trade than for its other uses, and that gold was generally the most universally accepted money for the last three thousand years. As people who hate gold are fond of pointing out, gold comes out of the ground, and nothing prevents someone from mining more of it. However, gold is quite scarce and quite valuable, and people have been looking for more of it for the last three thousand years, so the rate of discovery and mining is fairly predictable. An increase in the amount of gold through mining does not create inflation, because it is predictable, not to mention fairly slow.

Inflation can occur naturally in a country or geographical location due to circumstances. For example, when Columbus discovered the New World, no one anticipated the large amount of gold and silver that were found there. The concentrated mainly on extraction of gold and silver and experienced significant inflation as a result. Other countries that focused more on trade did not.

The major reason for the increase of gold is counterfeiting. One of the major problems with using money as gold is how can you be sure what you are getting is the real thing. Very early on, governments decided that they would take on the very important responsibility of certifying gold and other metallic moneys by making them into coins, certifying that a coin contained a fixed amount of gold or silver. They almost immediately began to cheat, clipping the edges of the coins or filling them to get scraps to make more coins; they used alloys and lied about the amount of gold in the alloy. If you ever wondered why the edges of coins are serrated, it is to make it more difficult to file the edges to prevent counterfeiting.

As the number of “gold” coins increased, the theory of marginal value reared its ugly head, and the money was valued less in relation to everything else, causing prices to rise. But notice that inflation comes first, then higher prices. The higher the inflation (rate of money increase) the faster and higher prices will tend to rise.

The process was made even easier with the advent of paper money. Paper money takes two forms: deposit slips and notes. Take your money to a bank and deposit your gold there and receive a deposit slip. That deposit slip can then be traded as though it were gold. Notes on the other hand are IOUs that come from the bank itself and can be redeemed in gold. The notes can then be traded and used for trade just like gold. Notes are inherently riskier than deposits, because how do you know if the bank is telling the truth? What if it has just been printing notes but acquiring more gold? If confidence in a bank falls, people will begin to redeem the notes for gold until a bank runs out of gold (goes bankrupt). This is called a bank run, the threat of which is the main thing that keeps banks honest.

Governments can do the same thing but on a grander scale. The main difference is that when a government goes bankrupt, it can do things like steal the populace’s gold as Roosevelt did in 1933. Executive Order 6102 made it illegal for Americans to own gold as money. Whatever was deposited in the banks already was simply turned over to the Federal Reserve. Americans were also ordered to turn in their gold coins and exchange them for Federal Reserve Notes (what today we call dollar bills). The gold was redeemed at approximately $20 per ounce of gold. A few short months later, the government sold its freshly stolen gold to Federal Reserve at the price of $35 an ounce.

There are many books that have told this story in far more detail, and I highly recommend reading them. But I will tell you the conclusion. Even though gold was illegal for Americans to own, the U.S. government was still obligated to pay gold to foreign banks in exchange for dollars. Eventually the drain of gold became so great that Richard Nixon stopped redeeming gold for dollars altogether. At this point, the dollar became what is known as fiat money. Fiat money is money that is backed by, well by, well…nothing. Because people were used to paying for goods with paper that represented gold, it was relatively simple to continue paying with paper that represented nothing so long as the government did not print too much money. Said another way, as long as governments only inflated a little bit, people did not notice too much–like the frog that is boiled slowly.

So why inflate in the first place?

Governments love to spend money, but they can only get it one of three ways. They can borrow it, they can tax (steal) it, or they can print it. The problem with borrowing it is that they have to repay it with interest. If they refuse to repay, then no one will lend to them. The problem with taxing is that it has a tendency to cause rebellions, riots, and the occasional beheading. Recall that one of the major reasons for the Declaration of Independence was dissatisfaction over taxing. Printing money, on the other hand, is insidious. It allows governments to spend money they don’t have. If a government has borrowed money, it can also repay the debts with less valuable money.

As discussed above, paper money made inflation easier. There are two other inventions that have made inflation even easier. They are fractional reserve banking and electronic banking. Fractional reserve banking occurs when a bank lends or issues more notes than it has reserves (traditionally gold). So if a bank has a million dollars and lends out two million, it is involved in fractional reserve banking. Remember that the major thing keeping banks honest is the threat of the bank run, and fractional reserve banking invites bank runs. To prevent them, the government instituted the Federal Reserve and the FDIC which insures all bank accounts up to $100,000. By law, banks can lend ten dollars for every one dollar of deposits. And that brings us to the second development. With the advent of fiat money and electronic banking, the government does not even have to print money any more. The Federal Reserve can simply add zeroes to a bank’s reserve account, and the bank can instantly lend out 10 times that amount.

The Federal Reserve also has another trick up its sleeve. Recall that increases in savings (decreased consumption) reduce interest rates, while decreases in savings (increased consumption) raises interest rates. The U.S. government has bestowed upon the Federal Reserve the power to simply change the rate at which banks loan to one another with a magic wand. Most famously, Alan Greenspan, the former Chairman of the Federal Reserve, lowered interest rates to less than 1%. Also famously, Paul Volcker, the chairman before Alan Greenspan, “slew inflation” in the early 80s by raising interest rates to the teens. Lowering the interest rate artificially has the de facto effect of printing money, while raising the interest rate has the opposite effect.

So what’s this about prices?

Redefining inflation as higher prices and deflation as lower prices is simply a marketing strategy used by the government. They can deny inflation by pointing to certain prices not rising or even falling. The CPI and PPI are numbers the government uses to support its claim. The CPI is the consumer price index which is a measure of things that consumers supposedly buy on a regular basis. It is the basis that the government and other businesses use to calculate cost of living adjustments. The PPI is the production price index and reflects the prices of common capital goods.

The problem with the CPI and PPI are twofold. First, the items in them change periodically, and the government sometimes changes the way it calculates them so that numbers from one year to another are not necessarily comparable. For example, if the price of steak goes up too high, the government will substitute the price of hamburger instead (although I’m pretty sure I could tell the difference). When the price of houses doubled a few years ago, the government substituted mortgage payments for rents, but who was renting when they were practically paying you to take interest only loans on a mansion?

The second problem is that they are often cited as indicators of inflation, when in fact, they are simply indicators of price. Recall that price is a reflection of value, and value is subjective. Prices rise and fall for many reasons, but the most common are a change in production or a change in society’s values. Inflation is competing with the natural tendency of prices to fall as productivity rises. If productivity is rising faster than inflation, prices will still fall, but that does not mean inflation is not occurring: if there were no inflation, the prices would fall even faster.

It is at this point when the government tries to pull a Tom Sawyer on the public. (For you illiterates, Tom Sawyer conned his friends into paying to perform his chores by pretending they were fun.) The government will then say that falling prices are deflation and bad. If prices fall, they claim that businesses will not be able to pay their bills and go bankrupt. They claim that the Fed will protect us from deflation as it delivers us from evil. But as we saw earlier, falling prices are in fact good, because they send information to both consumers and business. By inflating, the government is sending false signals to both.

The market goes up and down and around.

I hope you’re still with me, because this is where it really gets good. Almost everyone agrees with the above points, even though the government does not like to admit it. The key thing to remember is that inflation is an insidious form of stealing and as a byproduct sends false signals to consumers and businesses that cause them to do some rather strange things. One of the most important contributions of Austrian Economics is the Theory of the Business Cycle.

For years, economists and others have noticed that the economy seems to go through sudden booms where growth skyrockets and then even more sudden crashes or busts. This has is called the business cycle, the most famous of which is the Great Depression that followed the boom of the Roaring 20s. The business cycle is often blamed on the excesses of capitalism immediately followed by calls for government intervention.

Friedrich Hayek won the Nobel Prize for explaining the true cause of these boom/bust cycles. The major cause is government monetary policy. Inflation sends false signals to businesses. An increase in the money supply results in lower interest rates making it easier for businesses to get loans. In fact, there is so much money to be loaned that crazy business ideas that will never make a profit are funded. This is usually limited to one or two areas of the economy creating what is called a bubble. Bubbles often cause people to think normal business and economic principles no longer apply. In the 90s we heard talk of the “new economy” in which profits no longer mattered.

During the boom time, the affected companies or assets may huge increases in their prices. In the 90s, it was technological stocks; in the 2000’s, it was the real estate market. As the price of these assets goes up, people begin to speculate that the prices will never go down, and pour more and more of their money into them. They feel rich and begin to spend more and more money, but the problem is that even though there is an increased amount of money, there is no increase in actual capital goods and savings for these companies to use–in fact, there is even less, because people are spending and consuming more.

Eventually, these businesses will begin to fail, and people will lose their jobs, and the capital will be liquidated and sold to companies that are viable. As people realize that the wealth was illusory, the prices of their “investments” begins to fall and people will begin to sell their holdings and the prices will plummet. As people pull their money out of the bubble, they begin to value the money more resulting in lower prices throughout the economy. The lower prices are important because they allow people who have lost money in the bubble or their jobs to buy basic necessities more cheaply.

The money shot.

To recap, the Business cycle is caused by inflation causing artificially low interest rates, driving business ventures that are doomed to fail. Freeze right there. Most people, including the government, think that the damage to the economy is done during the bust when businesses go bankrupt and people lost their jobs. In fact the damage is done during the boom. Any time money is lent to a business that cannot succeed, that capital is wasted. That capital can no longer be used for something useful. The person who saved to make it possible has wasted his temperance. The bust is foul tasting medicine that sets things right.

Think about it for a moment. If you had a skin cancer, would you admire it, saying to yourself, “Look how vigorously it grows. If only all my skin would grow like this!” That is exactly what happens when the government tries to prevent a bust. The bailout of banks and car companies in 2008 and 2009 only keeps the cancer in the economy longer. The economy was damaged years ago. The bankruptcy of those banks and car companies would have gone a long way to setting things right. The problem is that it hurts to take our medicine, and John Maynard Keynes convinced us that the medicine is poison.

The cure for the boom is a bust, and the prevention of the business cycle in general is the removal of inflation and other detrimental government policies. Unfortunately, it is hard, and we are soft.