A Bit on Inflation

This article is about inflation. Yes, it's a dull economic concept, but it's critically important that you understand its significance in relation to the health of an economy. We know that if inflation is high, it is bad. If inflation is low, everything's OK. If inflation is negative, it's called deflation, which also seems to be bad. So it's good when price levels rise at a low rate. Right? Maybe.

Inflation is a flighty concept these days, and it's thrown around in the news media and general public as a number of decisive importance. In contemporary Keynesian economics textbooks, it's described as the process by which price levels increase. Technically, this is price inflation. In the United States, the main indicator of price levels is the Consumer Price Index. This was put together by the US Bureau of Labor Statistics in 1913, and has been released on a regular basis since. Naturally, for economists, such an index is a wonderful tool for measuring prices across a large economy.

However, inflation didn't always address a change in price levels. Many economists, particularly libertarians, define inflation as the change in the supply of money - that is, a change in the amount of money circulating in a system. This is a stable and controllable variable. It depends on the system of banking in practice at any given time, but in the case of our current fractional reserve banking system, the required reserves to capital ratio banks are mandated by law to hold in their vaults, the amount of money in the system is fully controllable and measurable. This is monetary inflation.

This definition is a far more useful indicator of both price levels and the strength of a currency. If the amount of money in an economy increases, then the rise of price levels is a direct effect. This correlation is based on the laws of supply and demand: when the supply of something increases, then its price or value decreases.

To draw a simple example: You are stranded on a desert island with ten other people. One person finds a pineapple tree, and he brings a pineapple back to the group, offering it to the highest bidder. In essence, he's constructed a basic market where there is a supply of one pineapple. One person in the group found two sand dollars, which he offers in exchange. The monetary supply consists of two sand dollars, and the price of the pineapple is two sand dollars. You come back with ten sand dollars, which you found in your wanderings, just as this transaction is closing. You offer four sand dollars. The money supply has increased to twelve units, while the price of pineapples has increased by two units to four sand dollars per unit. You just witnessed basic inflation.

When people have more money to spend, they can demand higher prices and so they will. When there is more money in the system, the goods in demand will experience an increase in price. Of course, in a fully functional national economy, there are far more factors than sand dollars and pineapples. An economist needs to take into account supplies, demands and factors of land, labor and resources. This creates a far more complex scenario, but the fundamentals remain the same.

To tie this into real life: today's United States government plans to inject about $11 trillion into the national economy in the space of less than two years. Many of this is unaccounted for at the corporate level and is distributed far from evenly. Regardless, when it trickles down through spending, consumption, investment and reinvestment, it eventually will be factored in by the various indices that the U.S. government and other organizations use to measure money supply, inflation and similar statistics. Nevertheless, the fundamental change in the amount of money in the system is the same. There is more money, so prices are higher. The result: inflation.

Unfortunately, the US government is looking the wrong direction. Accepted economic theory posits that when prices increase, inflation occurs, so they are looking at prices, perhaps not entirely aware of the fact that when the Fed and Treasury release hundreds of billions of dollars into the system, there will be a negative effect on inflation. To make matters worse, the way the CPI currently works, it does not account for food and energy - two of the most liquid and measurable indicators of inflation. Essentially, the CPI is used to measure inflation, but it doesn't actually incorporate two of the most prominent inflation indicators.

This approach is horribly flawed. It's resulting in a misdiagnosis of the problem, and a potentially disastrous prescription of a viable antidote.