by John | Jul 31, 2016 | Geopolitical Risk Protection, Liquidity, Preservation of Purchasing Power
I remember hearing about inflation as a kid and I remember asking “Why are my savings worth less each year?” What I was really asking was “What causes inflation?”
I might have gotten an answer about rising prices or more dollars in circulation but I didn’t understand. When I got older I did my own research and now understand the mechanics and causes of inflation.
Today I Explain What Causes Inflation
But before I do I want to make sure we’re on the same page regarding what Inflation is.
Inflation and Price Inflation are often used interchangeably, but it makes more sense to separate them out because one is the cause and the other is the effect.
Let’s define some terms:
Inflation: An increase in the money supply. An increase in the money supply is a fancy way of saying there are more dollars in existence than before.
Price Inflation: Rising prices as result of an increase in the money supply.
Inflating the money supply causes rising prices
An Example of the Effects of Inflation
Imagine everyone woke up one morning to find their bank account balances had doubled. The money supply had been inflated by a factor of 2!
Some people would choose to buy goods and services with their new-found “wealth”. But there aren’t more goods and services in the economy. Thus, consumers will bid up prices.
Basic laws of economics tell us that when demand increases and supply does not, prices rise.
Prices would then be higher as a result of the increase in the money supply in what is properly called Price Inflation.
What Causes Inflation?
Inflation is caused by creating new dollars. But who is creating these new dollars and how do they do it?
New dollars are created by banks.
The main bank responsible for inflation is the US Federal Reserve. But virtually all other banks also cause inflation via Fractional Reserve Banking.
The Federal Reserve Inflates the Money Supply
The US government spends much more than it brings in via taxes. To make up the difference the US treasury borrows money by issuing debt in the form of bonds.
This debt, these bonds, are then bought by investors, foreign governments, pension funds, and the central bank of the United States called the Federal Reserve.
If the debt was purchased with existing money this would not be inflationary. However, the US Federal Reserve conjures money out of thin air to buy US bonds. How do they conjure money?
They simply create deposits in the Federal Reserve accounts. Imagine if you could go into your bank account and type in that you now had 1 million more dollars. You’d be creating money out of thin air! That is what the Federal Reserve does.
The Fed has inflated the money supply. The Fed caused inflation by creating new dollars.
Using this this freshly minted money the Fed buys US government bonds. The US government then takes the dollars it got from the bonds it sold and spends it on tanks, government employee salaries, national parks, welfare, social security payments, you name it.
This new money that was created out of thin air by the Fed flows through the government into the economy and bids up the prices of goods and services for everyone else.
This resultant rise in prices is one of the effects of inflation.
A Second Cause of Inflation: Fractional Reserve Banking
Another cause of inflation is fraction reserve banking.
Fractional reserve banking means that banks do not have to keep all of their depositor’s funds available for withdrawal. Banks only have to keep a fraction (or portion) of their clients funds in reserve.
When you despot $100 into your checking account it doesn’t go into a vault and sit there. The bank loans that money out to other people or uses it to buy stocks, or bonds, or other investments.
Now banks aren’t allowed to loan out and invest all of their depositors money. After all, if you were to go to an ATM, you need to be able to withdraw cash, or when you write a check to pay your mortgage, the bank needs to send that money to your landlady.
Banks estimate how much money people will spend and withdraw over a given time and they keep that amount in reserve.
There are also regulations in place that dictate the amount of liquid dollars a bank must have in reserve. This is known as the reserve requirement. The reserve requirement is set by the Fed.
If the reserve requirement is 10%, that means that for every $100 in deposits, a bank can loan out $90. So, if you deposit a $100 bill into your checking account, the bank will loan out $90.
The person who received that $90 might spend it on a new pair of shoes. So they give $90 to the cobbler (shoemaker). The cobbler then deposits the $90 back into the bank, which can then be loaned out again. So the bank could make an additional $81 loan. This process repeats itself again and again and that $100 deposit, with a 10% reserve requirement, could become nearly $900 floating around the economy with only $100 in reserves in the bank.
So that little $100 bill has now become $1,000.
If you’re a more visual person you can check out this handy fractional reserve calculator.
So by not holding 100% of deposits in reserve, banks increase the money supply and cause inflation.
Do you have a better understanding of Inflation now?
The actions of the Federal Reserve and Banks cause inflation. I personally don’t like that my dollars are worth less each year because banks only hold fractional reserves and because the Fed prints money out of thin air.
This knowledge has led me to hold some money in gold. Unlike dollars banks can’t create gold by typing in numbers into a computer.
It also goes to show that if everyone were to try to withdraw their money from the bank at once the system would collapse. Don’t count on the FDIC, which is supposed to back up the banks, because it is undercapitalized. This knowledge leads me to hold some money in physical cash.
As I mentioned in a previous article the increase in money supply has caused dollars to be worth half a much since the year 2000.
Another one of the effects of inflation is the creation of bubbles (like the housing bubble of 2008) and the misallocation of resources. But that is a topic for another article.
by John | Jul 17, 2016 | Preservation of Purchasing Power, The Inflation Bandit
If a frog is placed in boiling water, it will jump out, but if it is placed in cold water that is slowly heated, it will not perceive the danger and will be cooked to death.
– Motto of the Inflation Bandit
There is a thief called the Inflation Bandit. He steals YOUR money every year. The ‘Bandit has been robbing and plundering since 1913. He has never been caught and he has never been stopped.
The Inflation Bandit Stole Half Your Money Since 2000
He is a terrible scoundrel and has robbed Americans of millions and billions of dollars but he’s also clever in an evil sort of way.
He doesn’t break into banks and steal money directly–after all that would be dangerous and he’d be caught.
How the Inflation Bandit Operates
The dastardly Inflation Bandit just prints up new money that looks exactly like all the other real money and spends it.
By spending his fake money into the economy he causes prices to go up for everyone else.
So while he doesn’t take your money directly he accomplishes the same thing by stealing the purchasing power of your money.
One of the Million ways this Master Thief has stolen from you
If the Inflation Bandit finds a car he wants he prints up fake money and uses it to buy one for himself and maybe even a few for his friends.
He buys up enough cars so that there aren’t enough left on the lot for all the people with real money to buy one.
When buyers can’t get what they want they tend to get upset. They complain to the car dealer. “I want to buy one of those awesome new cars but you’re sold out! Get some more ordered from the manufacturer!”
So when the car dealer orders more cars from the manufacturer, the dealer thinks, “Hey, people really love these cars! I bet I can raise my prices when I get more. That way people who most want the cars will be able to get one and I’ll make more money.”
Plus the dealer doesn’t like it when his customer’s come in and complain because he doesn’t have cars available for them to buy.
So now the price is higher for people who still want to buy a car. Because the Inflation Bandit used his fake money to buy cars he effectively stole from people who now have to pay the higher price for a car.
Don’t blame Business
It’s really not the car dealer’s fault he sold the cars to a thief. He didn’t recognize the Inflation Bandit. The ‘Bandit wears many disguises and his fake money is indistinguishable from real money.
The Inflation Bandit doesn’t just buy cars, he buys eggs, milk, gasoline, houses, movie tickets, iPhones, computers, cable TV subscriptions. He buys everything with his fake money.
And it isn’t like once the Inflation Bandit spends his fake money it is gone. That fake money is now mixed into the economy and bids up the prices of everything else.
The Inflation Bandit gets slowed down
Back in the late 70s the Inflation Bandit got especially greedy and printed up a lot of fake money. This was causing prices to go up by over 15% per year!
The ‘Bandit got away with it for a few years but people were outraged.
The government cracked down on his efforts and by the mid 80s he was on the run and printed less of his fake money so prices rose by about 5% per year.
Not a bad take for this master thief. He was still stealing millions upon billions but people were less concerned when prices rose by 5%. After all they had been accustomed to prices rising by 15%.
The ‘Bandit learned his lesson
The Inflation Bandit knows if he prints too much fake money people will be outraged. People will demand he be stopped or at least slowed down.
So he’s gotten smarter and he’s gotten patient. He knows that as long as he doesn’t create too much of his fake money each year most people won’t notice it and people won’t be motivated to stop him.
The Inflation Bandit also knows that if people do notice the rising prices they’ll likely blame greedy businesses.
He has a good chuckle every time a business gets blamed for his crimes.
Have you heard of Price Inflation?
While the Inflation Bandit might not be a real person. Price Inflation is as real as it gets. Price Inflation is caused by fake money being spent into the economy.
Price inflation means things cost more and your money can’t buy as much. For example, in 2000, a dozen eggs cost $.96. In 2015 a dozen eggs cost $2.75. That is over a 186% increase in price over 15 years.
Source: http://www.statista.com/statistics/236852/retail-price-of-eggs-in-the-united-states/
In the egg example that is a 7% average annual inflation rate.
Since the year 2000 I believe price inflation causes your money to be worth 5% less per year on average. This means when you try to buy things from food to gas and yes even electronics like iPhones and computers you’re paying 5% more each year than you otherwise would have.
Source: http://www.shadowstats.com/alternate_data/inflation-charts
Another Way to Understand Price Inflation
Lets say you lost a $100 bill in your couch on New Year’s Eve in 1999 and you found it on Christmas of 2015.
With an average inflation rate of 5% that $100 bill in 2015 now has the purchasing power of about $46 in 2000.
You would be able to buy less than half as much stuff! That means you’ve lost over half your purchasing power!
Don’t get Slowly Boiled Alive!
Imagine if you woke up one morning and someone had stolen half of your money. If you’re like me you’d be outraged. You’d call the police and demand justice.
But because inflation causes money to lose value relatively slowly over time it’s harder to notice.
People have had half their dollar’s value stolen over the past fifteen years and few people complain about it.
Like the proverbial frog in water, if the water is heated slowly enough, it will not jump out and be boiled alive.
Most people don’t think much about inflation and they don’t care. But if you buy things using dollars you’re being robbed blind by the Inflation Bandit.
There are ways to protect yourself from inflation thievery but you first have to realize you’re being boiled.
If you’d like to hear about the ways I put the beatdown on the Inflation Bandit click here.
