What is inflation?

I believe this is the most important financial question a person can ask. I am constantly on a trek to better understand money and wealth. Here is some of what I’ve learned thus far:

Per its original meaning:

• Inflation is not a rise in prices
• Inflation is a rise in the money supply

I have a 1920 Webster’s dictionary that says inflation is a rise in the money supply. I have a 2006 Webster’s dictionary that says inflation is a rise in consumer prices. From this point forward, I will use “inflation” for its original definition (an increase in the money supply) and I will use “price inflation” to refer to a general increase in  prices.

How did this “Newspeak” happen?

Inflation is harmful because it leads to a rise in prices. When everyone’s expenses are rising faster than their incomes as a result of the actions of the government and banking system, it is like a tax on the American people.

With the harm being a rise in prices, the focus on the topic of “inflation” shifted from the cause (inflation) to the effect (rising prices). And so, over a period of decades, everyone (news media included) shifted into speaking about inflation as a rise in prices.

Why don’t inflation and price increases correlate directly anymore?

You can take simple economic examples and draw a direct correlation from increasing the money supply to a rise in prices not complemented by a rise in incomes. These are usually fictional stories of a group of people being stranded on an island and creating their own economy. They will illustrate with great clarity that increasing the money supply takes from the regular person and gives to the banker or his friends (such as the government).

Now apply those concepts to our current economy and you will be so confused, it will be easy to surrender to saying, “Gosh this stuff is for super-geeks to figure out and I’ll just go with whatever is reported to me.” Of course, we’ve learned that following the crowd and getting your information from normal reporting sources is a sure way to be led off the edge of a financial cliff.

Why do these simple concepts work in simple, theoretical economies and not our real economy? Why can’t we draw a direct correlation between inflation and price increases? We are on a trajectory away from a free market. Our country started with a 6 page Constitution. People and businesses were once operating in a free[er] market. We developed our understanding of the economy based on a free market. Today we have over 100,000 pages of laws and regulations. And each year we add to the pile. Almost every law interferes with the way things occur naturally. And almost every law takes us one step further away from a free market.

Our understanding about economics and money is based on the past, but we are in the present. In the case of inflation and price inflation, manipulations make the connection difficult to see. In a free market, inflation would create  price inflation clearly and directly. But in our economy, the government has already tinkered with prices in countless areas. There are subsidies, tariffs, minimum price mandates, maximum price mandates, etc, etc. The buyers and sellers of the market don’t come together to determine price. They come together to try to transact within the confines of the 100,000 pages of laws and regulations that the government imposes. Within that system the price of one thing may skyrocket while other things stay the same.

What does monetary inflation do today?

In the case of the housing bubble, the Fed created tons of money through interest rate manipulation. In a free market that new money would have gone everywhere and prices of everything would rise. In our actual market, Fannie Mae and Freddie Mac (government-sponsored enterprises or GSEs) then attracted mortgage borrowers in ways that non-GSE private businesses couldn’t. That directed all of the new money into real estate and took its prices to the moon and then back down to earth. Now we all have whiplash and lighter pockets.

Meanwhile, the government organization that measures price inflation (BLS) has found that reporting price inflation (through CPI, the Consumer Price Index) is quite challenging. “Man, what do we do?! The prices of certain things are moving erratically!” thought BLS. They (and other governments) decided to make many adjustments to not count things rising rapidly in price. Through many phases of altering their calculations and adjustments, CPI charts have effectively become pieces of art with the economic utility of a Jackson Pollock piece.

The other day, somebody sent me a link to this chart and asked me what can be drawn from it. I replied that data was gathered, processed and reported differently from one decade to the next. It would be like taking the price of apples in the 50s, bananas in the 60s, oil in the 70s, cotton in the 80s, and wheat in the 90s. Now put that onto a chart. What does it mean? Nothing. Just like price inflation. CPI didn’t report the same thing 20 years ago as it does today, and putting the different reports on a chart and connecting dots with lines is almost as arbitrary as children’s connect-the-dot puzzles.

The difference is the child knows it’s a meaningless game. With our arbitrary line graph puzzles, we make big decisions based on them. Ouch.

The U.S. House is going to debate the “Audit The Fed” bill. I don’t pay close attention to what’s being debated and passed on the floor of the Senate of House of Representatives because what’s usually written up, sponsored, and voted on isn’t even read by our Congressmen.

This Audit the Fed bill is a different story. It’s sponsored by a Congressman who some call the only honest politician left… Ron Paul. He’s often called “Dr. NO” because he is a medical doctor and he regularly votes against any bill for which the U.S. Constitution doesn’t give Congress the power to pass, no matter how seemingly good the benefits are. Suffice it to say that when Ron Paul votes “yes” on anything, it is a rare occasion.

So to see him sponsoring a bill that is getting attention is even rarer. His objective to audit the Fed is a just a stepping stone to ending it. One CNBC commentator agrees that the Fed would be shut down if audited.

In fact, that’s the reasoning behind the opposition to the bill: if we knew what the Fed was actually doing we would have no confidence in it. Wow. That’s not a very good argument to get us to stop wondering what they’re doing over at the Fed.

See more at http://digg.com/d1tbIf

While everyone argues about what the government should be doing, 2 very fundamental factors are ignored.

In this video I discuss those factors. One thing I didn’t include in the video…

You may say “Jeff, you can’t say that government doesn’t do some good.” You’re right I can’t. I will address that in a soon-to-come post.  Check it out; comments encouraged  

• Banks need about $75 billion to reach “adequate capitalization”
• “Adequate capitalization” is when common equity equals 4%
• Common equity being at 4% means a debt-to-equity ratio of 25-to-1
• The current bank needs do not factor in the potential for bank assets to lose their value
• The current bank needs are based on a rosy worst case scenario of a 3.3% drop in GDP this year and unemployment of 8.9%
• The government’s latest understated unemployment data is already reporting unemployment at 8.9%, so the government is trying to convince us that the worst case scenario is unemployment stays the same

Additionally, here are what some of the larger banks needed according to the stress tests:

• Citigroup $5.5 billion
• Wells Fargo $15 billion
• Bank of America $34 billion

Keep in mind that these are the amounts of money that must be given to the banks now in order for the banks to get themselves UP to a 25-to-1 leverage ratio. Also, while Citigroup appears to be less incompetent than Wells and B of A, a recent article in Time magazine says that Citi “got credit for a capital conversion it has yet to complete. Strip that out, and the amount of capital Citi needs balloons to nearly $63 billion, more than any of the other banks tested.”