Inflation? Deflation? Stagflation?

Inflation is one of the Internet’s favorite buzzwords. But what are we really talking about? There’s more to it than most think.

Two common misunderstandings obscure the issue: mixing two different definitions and ignoring the different behavior of inflation in different monetary systems.

The first issue is fairly well known: there are two commonly used definitions for inflation.

The classical definition for inflation is a growing money supply.

The ‘modern’ definition is rising prices.

The classical definition is much better. Inflation may or may not result in rising prices. And, as we will see, in today’s system the rising prices are not caused by inflation.
A different thing in different systems
The second thing to keep in mind is that inflation means different things under different systems.

In a debt free system, simple money printing and spending into circulation a la the Greenback or Social Credit, the situation is the most straight forward. When the economy is operating at near maximum capacity adding more money to the money supply will lead to rising prices. If the economy grows, more money must be added to finance the additional trade and maintain full employment.

In our current system the situation is far more complex because there is interest on the money supply and this leads to all sorts of unexpected and counter intuitive side effects.

The basic problem is that if there is interest there is never enough money to pay of the debt + interest, because only the debt is created. Mathematically perfected economy™ provides us with the basic math.
It looks like this: P + I > P where P is the Principal and I is Interest.

What this means is that the demand for money is always more than there is in circulation. If P = 100 and I = 5% then P + I = 105, while there is only 100.

Thankfully the banker is kind enough to lend us the 5 to pay the interest also. Which means that after a year the money supply will be 105. But the demand for money will be 105 + I. etc.

This means inflation according to the classical definition. But do prices rise? No, because the effective money supply remains the same: all the extra money is just being created to pay off the interest.

So interest on the money supply has a deflationary effect. When the money supply is paper based, the banker can create new credit to finance interest payments, but that extra credit in turn will require debt service also.

With a Gold Standard the situation would be much worse: because the bankers would not be able to create extra Gold to pay for the interest, there would be eternal deflation because of ever higher interest costs on the circulating Gold, leaving ever less for normal trade.

So in our current system inflation is inevitable, but we do not expect rising prices because of a growing money supply. The money available for trade remains stable while the money supply itself grows.

Still we have seen that the Dollar has lost 97% of its purchasing power since 1913. So how can this be?

Well, since the money supply is interest bearing debt and since the money supply grows, the cost for money must grow also. And this is what is driving up prices all through the West: ever higher cost for capital as a result of an ever growing money supply.

At this point costs for capital already account for 45% of prices we pay.

This also explains why we must have economic growth every year: it is to pay off ever more interest. If the economy does not grow, we would see real incomes decline. In fact, over the last few decades, since the end of the post war boom in the late seventies real wages have been declining throughout the West. The reason being that the economy grows slower than capital costs.

Recapping: we have inflation in the classical meaning of the word, but this is not causing prices to rise as the effective money supply available for trade remains the same. Prices still rise, but this is not the result of inflation, but because of ever more interest payed over an ever growing money supply.

The Current Depression
So what is our current situation? Are we facing (hyper) inflation? The standard case for hyperinflation is this graph:
This is the Fed Balance Sheet: it certainly suggests massive expansion.

But here’s the graph showing the growth of the money supply:
As we can see M1 (cash + liquid assets) started to grow rapidly in the aftermath of Lehman’s demise. But M3 (a wider definition of the money supply, including assets harder to liquidate) started tanking badly. Even today it is growing much slower than before the depression began. And how about this graph:
This is the velocity of circulation. The real money supply is money times circulation and slower circulation means a smaller effective money supply.

This is why the Fed started printing extra money, leading to an expanding M1: the real monetary base as expressed with M3 was declining and a horrible contraction of the economy would have resulted without the Fed’s interventions.

When we look at prices, we get conflicting information. Paper assets and real estate are much down since 2008. But prices for food and energy are rising. Meanwhile the economy is tanking. This combination is known as stagflation.

Asset prices are down due to a contracting money supply as seen in the stats. Rising prices in the primary sector are explained by speculation on the commodity markets, driving up prices. These price rises are passed on throughout the supply chain. But this is not inflation: it is not a growing money supply that is causing these price rises, it is artificial demand created by Hedge Funds and the like.

Current Government reports on inflation suggest there is no problem. The Fed says inflation is about 2%. But its figures are unreliable: over the last decades the methodology to calculate the CPI has been manipulated to show lower numbers. Shadowstats, using the old ways, reports inflation of about 6%. This is relatively high, but still not quite hyperinflationary.

For the time being we can expect rising prices for our daily needs, while assets will continue to be depressed. In the longer run the question is whether the Fed can take the extra liquidity it created out of the system when velocity recovers. If it can’t we can expect more rising prices. But as long as the economy remains depressed as it is, we will have a combination of deflationary pressures in the domestic economy as a result of limited lending by the banks, combined with upward price pressures due to speculation on the commodity markets.

So why is Gold rising?
Normally speaking Gold would be depressed during deflation. So why has it been appreciating so much? Clearly it’s not just a hedge against inflation: it has appreciated too much for that.

The point is that Gold is regaining monetary status and more and more people are betting it will be money again. Demand for Gold will remain high as more and more nations are abandoning the Dollar as their medium of exchange for international trade. This in itself brings even more inflationary pressures for the dollar, as more and more of them are repatriated as they are no longer needed for international trade.

Conclusion
We don’t have inflation because of ‘irresponsible politicians’. In fact, if we look at the growth of the money supply since the War and correct it for the extra liquidity created to pay the interest, it was probably about 40%: not even enough to finance extra production through economic growth.

This sheds a different light on the popular claim that ‘politicians are debasing the currency’ or on the notion that fiat currencies are per definition inflated into oblivion.

Prices have been rising not so much because of inflation, but due to rising cost for capital.

This suggests a normally functioning currency board monitoring a non-interest bearing money supply should be able to manage the money supply effectively and maintain stable prices.

Currently the situation is more complex: there is a combination of both inflationary and deflationary pressures. Prices seem to be rising for food and energy, while assets remain depressed.

It is not rampant printing, but speculation in commodities and dollars being brought home because they are no longer needed internationally.

These conflicting trends make the situation obscure and it is difficult to make real predictions. Hyperinflation seems unlikely for the time being, but purchasing power will continue to decline for most people. Assets are declining in value, while the prices for our daily groceries and fuel and increasing.

Declining purchasing power and economic activity will continue until the Money Power has achieved its goals or until we find other ways.

Related:
Phoenix Rising, the Return of the Gold Standard
Why Gold is so strongly deflationary
Stagflation explained……..at last
Why is Gold appreciating?
Dealing with Inflation