Wednesday, 18 November 2015 13:21

Some Thoughts on Inflation

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Some Thoughts on Inflation

David J. Bean

David J. Bean is a freelance writer living in California.

Everyone knows what inflation is: It is the increase in prices over time; the increase in prices this year as regards to last year or a number of years ago. Simple!

But is it really that simple? A classic definition of inflation is "an increase in the price of a good or service without a corresponding increase in value." And that works pretty well except now we are stuck with a definition of value. When you think about value you have to realize that it is always considered in relation to something else. This is more valuable than that, etc. So the value of any good or service must be compared to something else before we can determine its "value." And unfortunately, there is no international standard for determining what anything should be compared with in order to determine its "true" value. It used to be that most countries used gold as their standard for determining value, and many still do, but since no country is on the gold standard now, that is not a rock-solid base. And besides, gold prices change drastically, too.

The problem with gold is to find something solid to compare it to. Most of us compare it to the number of dollars it costs. But when you think about what money really is you can see the problem. Money is an IOU. It promises to be exchangeable for a good or service at a later date. But if that date is very far in the future, money (or the dollar) is not a very good store of "value" because of inflation. Thus, with gold at $700+ an ounce it is being compared to the value of a dollar with the hope that if the value of a dollar goes down, the dollar price of gold will go up. But this is not necessarily so. In the 1970s the price of gold was over $800 per ounce but not too many years later it had fallen to less than $300 without an equal corresponding change in a dollar's value. And when storing gold (as a store of value) one must consider storage costs and the lost interest that could be obtained by an equal investment in stocks or bonds. So gold in itself is not a rock-solid storage of value either.

For years many people thought land was the best storage of value. And land prices, in general, do go up over time. Do they go up more than inflation? Some times, but once again, there is no guarantee. And land can be taxed, flooded, or zoned into less value. So land can be a good storage of value but there is still risk involved.

The Federal Reserve Bank uses a "basket of commodities" as a standard in measuring inflation. This is so they can remain "modern" in what commodities are popular. It would be silly to use the price of buggy whips these days as a mark of inflation.

We can get a pretty good idea of the effects of inflation but we haven't really determined what causes inflation.

Most economists say that inflation is caused by "too much money, chasing too few goods," but when you examine this theory in specific cases it doesn't make sense. Shortages certainly can cause a short-term spike in the price of a good or service, but for a long-term trend in price advancement we have to look at other causes. For example, is there a shortage of gold? NO; we have enough in Fort Knox to build a fence clear around Texas, and in spite of the fact that with the computer age we are using a lot more gold for electrical contacts, jewelry etc., more is being mined every day. Other countries also have huge stores of gold. Or more simply, how about the price of bread? Is there any shortage of bread? NO, again, yet its price is approaching $4 per loaf. Well, how about the price of an automobile? Certainly there is no shortage of those, but look what their prices have done in the last ten years.

Many economists believe inflation is caused by the creation of too much money. The government prints the money but banks create it. With our fractional banking system banks can lend out more money than they have on deposit or reserve; sometimes as much as ten times as much. Thus, our banking and loan system creates money. These banks are restricted by the amount of reserves they must hold, but when they get low they can borrow from the Fed discount window and these loans go into their reserve so they can loan the public more money. The banks pay interest on their loans of course. The Fed tries to control the amount of loans banks can issue by raising or lowering the interest rates on the loans to the banks and thus tries to control the amount of new money that the banks can create.

So the dollar, which has been the de facto standard in the world for years, is starting to lose its position as a standard of value, a unit of account, a store of value, or a medium of exchange. Most of this loss can be attributed to the devaluation of the dollar with respect to other currencies. When the euro was introduced it was valued at less than a dollar; today it is worth $1.41. This makes things much cheaper for European countries who buy U.S. goods or services but makes all our imports from them much more expensive. What this really reflects is a lowering of the perceived value of a dollar in relation to other currencies.

A nation's wealth is not determined by the amount of currency it has afloat; it is determined by the amount of salable goods or services it produces. The value of this production is usually expressed in terms of GDP or Gross Domestic Product. The U.S. has been, and still is, the leader in gross production, but the rest of the world is catching up. Think of our gross production as a huge pile of units, some of which are exported but most are consumed by ourselves. We buy most of the cars, washing machines and other things we produce ourselves and, in fact, import and consume more goods than we export. Thus we experience a "trade gap." We import and consume the goods or services and give the foreign producer dollars in exchange. These dollars are IOUs for future goods or services that all of the U.S. producers have to cash at some future date.

Europe is starting to feel the bite as the U.S. dollar plummets, making French wine, Italian fashion, and German cars, more expensive in the U.S., the EU's main export market. The Wall Street Journal reported that the employer group BusinessEurope said that the euro had crossed a "pain threshold" for European companies.

Governments in general do not directly contribute to the GDP, but government policies can promote or restrict production in specific areas. In fact, governments are really consumers of production because the costs of government must come out of that pile of units that the working citizens produce. In a well-governed country the taxes paid by the working section (which is the portion of the production units taken by the government) would equal the amount spent in providing government services. For the last series of decades, however, the U.S. government has been spending and obligating a whole lot more than the producers have been able to produce. The result is a huge working deficit and an even larger future obligation brought on by unfunded promises Congress has made. The result is trillions of dollars of debt to cover present and future obligations that no one has any idea how to pay. The current year deficit in the spring of 2007 was predicted to be over 400 billion dollars. Thus, the world's investment communities have a loss of confidence in the future value of the dollar with the result that its value with respect to other currencies has dropped.

Of course inflation can help pay this debt by letting the government pay the debt with dollars that are worth a whole lot less than what they were at the time of the original borrowing. This is what politicians count on and it provides an incentive for people to invest using borrowed funds. What this system does, however, is rob savers who are stuck with investments paying a lower interest than inflation. And for current investors it makes savers require higher interest when they invest. A saver must receive a higher return than the projected inflation rate or he is guaranteed a loss on his investment.

Well, why don't we just raise taxes enough to cover what the government is spending and obligating? For one thing, taxes are a strong disincentive to production and hurt the economy. Also, politicians are afraid to call a halt to all this credit card-type spending by telling the people that the bill is finally due and payable. The government is already taking over 20 percent of the production now (but in reality, taking twice as much -- see below) and obligating a lot more than that. And taxes contribute to inflation because there are literally thousands of taxes today that were not imposed as recently as fifty years ago. For example, a recent study concluded that there are over 20 Federal taxes on a simple phone call and countless state and local taxes on top of that. A recent Associated Press article on food prices said that a bowl of cereal and milk cost 49 cents this year as opposed to 44 cents last year. The article also dissected a dollar spent on food and concluded that for each dollar spent, 38.5 cents went to labor, 19.5 cents to farm products, 12 cents to advertising and packaging, 7.5 cents to transportation and energy, 7 cents to rent and insurance, 6 cents to direct taxes and 9.5 cents to depreciation and profit.

It was pointed out in an August 2007 St. Croix Review article (page 53) that ultimately consumers pay all taxes. The article shows that when a person consumes a good or service he is paying a portion of all the taxes paid by all the people who had anything to do with bringing that product or service to the market because all their taxes (which they paid out of what they were paid) were expensed and are included in the price consumers pay for the product or service. This rather simple concept is not universally understood but nevertheless is true. The implications of this revelation have not been discussed or debated but it does show that the progressiveness of our tax laws is a pathetic fraud. Also it shows that we collectively pay all taxes twice! Don't believe it? Take a hypothetical CEO who makes $1 million per year. Assume he pays $250,000 in taxes. The quarter million goes directly to Washington but is expensed as part of his salary so goes into the cost basis of the product or service his company produces and is paid again by the consumers who buy that product or service.

Now look at the Associated Press breakdown of the cost dollar above. In each one of the items that involve people such as labor, farm value, advertising, transportation, and rent, the pay those people receive must cover all of their tax obligations. Assuming that is their only job, where else could they get the funds to pay their taxes?

All of the above suggests that long-term inflation is caused by the general belief that a future dollar will not buy as much as a present dollar. This belief is reinforced by the knowledge that Congress keeps spending and obligating future wealth, no matter that the Secretary of the Treasury has stated many times that he believes in a strong dollar. As long as this deficit spending continues we will experience inflation. Deficit spending has now been practically constant for the last 40 years and totals several trillion dollars and now is still over 260 billion for this year, 2007.

Politicians obligate government's share of the production to the extent they can without being held accountable for the resulting deficit or the potential collapse of the economy. They use class jealousies to set the lower producers against the higher producers and constantly try to level the share of production that is distributed through our economic system. This tendency toward pure democracy is dangerous because when 51 percent of the nonproductive masses find out that they can vote themselves an unearned share of the production, many of the 138 million producers we have will quit producing.

A democracy will continue to exist up until the time that voters discover they can vote themselves generous gifts from the public treasury. From that moment on, the majority always vote for candidates who promise the most benefits.

[The origin of the above quote is unknown. Some have attributed it to Alexander Fraser, Tytler, more formally known as Lord Woodhouselee. Others attribute it to Lord Macauley or Alexis de Tocqueville.] *

"Timid and interested politicians think much more about the security of their seats than about the security of their country." --T. B. Macaulay, Speech in House of Commons, May 1842

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