Inflation Is a Four-Letter Word

05/27/2011 8:00 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

What is inflation? And what does it have to do with the great debate over our national debt?

As I listened to the winding conversation on inflation at a dinner party a few days ago, I realized many don’t understand how this crucially important process works, and even fewer grasp the devastating impact it can have, even at a relatively low rate.

For example, at only a 3% average inflation rate, if you had $600 in 1960, it would now take $2,900 to have the same buying power in 2011.

And if you retire now, thinking that an annuity paying $3,000 a month will cover your expenses, you’ll be shocked to know that in 25 years you will need $6,000 a month just to cover those same expenses.

And that’s with moderate inflation! Few people remember the late 1970’s, when inflation soared to double digits, amidst the Fed’s spree to create money to pay for the Vietnam War and cushion citizens from soaring oil prices.

Could it happen again? Do we understand how inflation happens?

Even if most prices aren’t currently rising, according to the Consumer Price Index, inflation is eating away at our buying power. And the CPI figures we quote exclude food and energy, and don’t fully reflect the rising cost of college and medical care. Maybe it’s time to take a closer look.

Inflation is not just rising prices. Rising prices are a symptom of inflation—the visible way we measure the impact of inflation. And lately, our debt has become a cause of potential inflation—because of the way we’re dealing with it.

Technically, inflation is just the creation of too much money. That makes it a phenomenon caused by the Federal Reserve, our central bank, which is in charge of our money supply.

Think of it as a giant game of Monopoly, with the “banker” passing out money. Remember those $500 bills in the old Monopoly board game? Well, suppose the banker wanted to get the game moving, and decided to pass out more money. And suppose, like in real life, when you landed on a property everyone could bid for it.

Say you’d been saving one of those $500 bills to buy Boardwalk or Park Place. Suddenly, with more money in the game, your savings would have less value. And the price of those two prime properties would be bid higher, not because of any inherent change in their value—but simply because there’s more money in the game.

That’s inflation.

NEXT: Beyond the Printing Press

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Beyond the Printing Press
These days, money creation has become an electronic process, not just a matter of running the presses and printing currency.

To create “money,” the Fed simply goes into the marketplace and buys securities, ranging from government bonds to mortgages—paying for those purchases with a credit on the books of the banks and other institutional sellers. In an instant, that credit means new money is created and pushed into the system.

The Fed has been creating new money (credit) at an unprecedented rate. They even have a name for the process: QE2, which stands for the current round of “quantitative easing.” That plan is expected to end in June, bringing with it some fears that the economy will slow down.

Where Did it Go?
Given that huge round of money creation, it’s amazing that we haven’t seen rising prices already—except in commodities that are traded globally. Perhaps, it’s because that newly created credit is sitting on the books of banks that are afraid to lend, or businesses that are afraid to expand.

The major aspect of inflation is the “creation” of money. But another aspect is the “velocity” of money—how quickly it is moving through the system.

Despite the Fed’s unprecedented rate of money creation, velocity has been very sluggish. That credit isn’t being pushed into the economy through loans and business expansion. And so our economy sits in a continuing quagmire of slow economic growth and high unemployment.

But like a buildup of natural gas, that money sits, silently waiting for the spark of inflation to ignite. And that spark might come from the fact that the entire world uses dollars as a pricing standard for globally traded commodities, such as oil.

The spark? A sudden realization that too many dollars are being created to repay our debts.

D-E-B-T
The Fed’s attempts to create economic growth through money creation wouldn’t be so much of a problem if we didn’t have such a huge national debt.

But that growing debt means we have to borrow money, much of it from foreigners. China and Japan hold nearly $4 trillion of our IOUs, a hefty chunk of our $14 Trillion national debt.

As we keep going deeper into debt, we’re borrowing more—and our creditors are beginning to wonder how we’ll ever repay that debt. Just last month, the Chinese foreign minister warned the United States to “be responsible” about its growing debt.

Our lenders know that the more dollars we “create,” the less buying power each dollar will have—much as in the Monopoly game. And two things will happen:

  • They will demand higher interest rates when they lend money to us, in order to compensate for the falling value of the dollars which they will be repaid. Higher rates will hurt our economy, but we’ll have to pay them to borrow the money.
  • They will scramble to get rid of those dollars that are losing buying power, turning instead to real commodities like gold, and oil, and farmland, and industrial metals, and minerals. It’s already starting to happen.

That’s the relationship between inflation (money creation) and debt. Rising prices are a symptom of a growing global concern about the future value of the dollar—simply because we are creating too many of them as a way of dealing with our rapidly increasing debt.

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