Tuesday, July 01, 2008

Real Inflation

Frank Shostak gives the Austrian view of inflation in this article. Inflation is not the rise in the CPI. The rise in the CPI is a symptom of inflation in the Austrian view of things. Very simply, an increase in the supply of money is inflation. As Mr. Shostak puts it:

In the modern world, money proper is no longer gold but rather paper money; hence inflation in this case is an increase in the stock of paper money. Please note we don't say, as monetarists do, that the increase in the money supply causes inflation. What we are saying is that inflation is the increase in the money supply.


Of course, money today is not just "paper money". The Federal Reserve doesn't have to actually print up more dollar bills (or 20s or 100s) to commit the sin of inflation. Our system is structured such that the banks in the system (and other participants such as Fannie Mae) are actually complicit in the inflation of the money supply. A true measure of money creation has to take into account the creation of credit. What we have just witnessed over the last several years was a credit creation bubble enabled by the Federal Reserve holding interest rates artificially low.

The price rises we are seeing now are a result of previous inflation. I'm not sure where we stand today, but it appears to me that the Fed is having trouble inflating because the banks aren't lending. Bank credit and commercial paper outstanding are both contracting:






On the other hand, True Money Supply is going vertical:



So, while there is no doubt the Fed was inflating during the period of extremely low interest rates of the early part of the decade, I'm not sure that is what we are getting right now. The bust after a credit boom is generally considered deflationary and the drop in housing prices would seem to confirm that. I suspect that commodity prices will start to reflect today's credit destruction at some point in the future.

I don't think the commodity price rises we are seeing right now are a result of what the Fed has done over the last 9 months since the sub prime mess hit fan. I think it is a symptom of prior inflation. If that is true and the credit destruction we are seeing today is deflationary, we should start to see commodity prices fall relatively soon.

Another point about inflation that Shostak makes well is that the first receivers of new money are beneficiaries and the last receivers (poor people and savers) are hurt the most:

Likewise, it is monetary inflation, and not increases in prices, that erodes the real incomes of pensioners and low-income earners. As a rule, they are the last receivers of money — often called the "fixed-income groups."

According to Rothbard,

Particular sufferers will be those depending on fixed-money contracts — contracts made in the days before the inflationary rise in prices. Life insurance beneficiaries and annuitants, retired persons living off pensions, landlords with long-term leases, bondholders and other creditors, those holding cash, all will bear the brunt of the inflation. They will be the ones who are "taxed."[3]


I believe this is the source of the wealth and income inequality that liberals are so concerned about. If that is true, it won't be solved by raising taxes on the rich. In fact, I suspect that will only make the problem worse. Solving the inequality problem, and many of our other economic problems, will require that we properly define inflation.

1 comment:

Julian Campolo said...

Right now, we are overweight commodities, so what indicators do we look for that trigger us to reduce our commodity position? Are there concrete signs, or is it more of a portfolio manager's intuition?