In the deflation article we established that deflation is an overall decline in price, or increase in the value of a given currency unit.  In other words, your dollar goes farther.  We also established that inflation is the opposite of that.  Pretty simple, right?  Your dollar buys less and less the higher inflation goes.

We generally measure inflationary rates according to one or more price indexes.  The one everyone is familiar with is the Consumer Price Index, also called the Cost of Living Index.  Other indices are useful as well when measuring inflation in narrow parts of the economy but we’ll use the CPI for the purpose of this article.  The annual inflation rate is simply the annualized percentage change in the CPI as measured by the federal government.

Inflation is bad, isn’t it?

Not inherently.  Just like deflation, inflation is not good or bad in and of itself.  In fact most economists believe that low steady rates of inflation are a good thing for an economy.  The key is that the inflation rate should stay below the growth rate of the economy at large, or the Gross Domestic Product as we call it here in the United States.  Mild inflation is also key to getting out of a depression or recession.  Mild being the key word there.

On the flip side, inflation can do some bad things.  If inflation begins to rise too high there is a natural response by consumers to spend their money on tangible durable goods before that money is devalued too much.  If you recall in the deflation article we talked about supply and demand and how it drives prices.  If consumers begin buying durable goods, prices go up as demand goes up and that has a circular effect I’m sure you can all see.

Another negative side effect of inflation is something called Cost Push Inflation.  It’s basically the concept that as consumer prices rise, employees demand more and more cost of living increases to keep up.  This is particularly negative with collective bargaining agreements like union contracts and the like which are tied to the CPI.  It can trigger a wage spiral which has the further effect of increasing the inflation rate as businesses raise prices to compensate for higher employment expense, leading to higher wages, ad inifintum.

What happens to debt in an inflationary period?

That depends on the type of debt.  A fixed interest loan, such as a standard mortgage or a contractual loan will become cheaper to pay off.  A variable interest loan will stay about the same in compensated value, but there is a real danger to variable interest rates.  The interest rate will ALWAYS rise faster and farther than your wages will.  Always.

Rudy’s Tip: Inflation adjusted interest rates on fixed interest loans are called ‘real’ rates.  It’s defined as the nominal rate minus the inflationary rate.  So if your fixed interest rate is 8% and inflation is 3% your effective rate is 5%.  If inflation jumps to 8% then you’re essentially paying no interest.  Beyond that and the bank is essentially paying you for the loan.  Funky!

What causes inflation?

Well, if you’re an economist this is where you start talking about the Quantity Theory of Money, the Velocity of Money, Currency Debasement, and other interesting things.  Since we’re in a fiat money economy we’ll limit our discussion to that.  There are really two things that matter in the long run.  The money supply and economic output.  If the supply of money increases too quickly compared to the economy at large that inevitably leads to price inflation based on the law of supply and demand.

Interest rates also play a part here as higher interest rates lead to lower inflation rates and vice versa.  This is why you see a reduction of the federal funds rate in an attempt to kick start the economy.  The theory here is that if money is cheaper to borrow more people will take advantage of that leading to more economic growth and thus higher inflationary pressure.

Great Ceasar’s Ghost!

A random final bit of information here.  I talked about currency debasement in the last section.  Debasement in its purest form is when you take a commodity currency (like a gold coin) and melt it down, then recasting the coin with a lower commodity content.  Most historians believe that debasement was one of the leading causes of the fall of the Roman Empire.  The Roman silver  denarius was 95 percent silver when introduced.  Over a one hundred year period it was debased so far that it only contained 0.5% silver.  Yowza.

Couldn’t happen here, right, since we’re in a fiat system?  Nope.  Debasement basically takes a unit of currency and reduces it’s value.  What do you think the Fed printing presses running overtime does to our currency values?

Wrapping Up

That’s it for inflation!  Conceptually pretty simple, especially after reading the deflation article I wrote.  Next we talk about Inflation Gone Wild.  Also known as Hyperinflation or Something That Keeps Rudy Up At Night.  Stay tuned!

What is a currency?

Simple, right? It’s the money that sits in our wallet, or our bank account, or under the mattress. We use it to buy stuff! In its purest form a currency is something that is valuable or represents something else of value. This could be anything you consider to be worth something. That could be a precious metal, grain, land, or maybe even yak beard clippings. In any case, currency at it’s base simply represents something that is uniformly considered valuable. If you don’t value yak beard clippings, you probably wouldn’t take a piece of carved wood that represents five pounds of clippings in exchange for a meal.

What is a commodity currency?

A commodity currency is pretty much what it sounds like.  It’s something that is intrinsically valuable.  That could be fish hooks, gold coins, or FizBats.  It’s really all about what is intrinsically valuable to the parties involved in an economic transaction.  Typically throughout history commodity currencies have been precious metals (gold, silver, copper, etc) or gem stones.

What is a representative currency?

A representative currency is, oddly enough, a currency that represents something of value but is not in and of itself valuable.  For example if I hand you a piece of paper that says ‘Rudy Kearney will redeem this paper for one gold bar on demand’ then that is a representative currency.  A centrally issued bank note that is redeemable for something of value is also representative.

What is a fiat currency?

A fiat currency is something that has worth because the issuing central bank and the government say it has worth.  As long as participants in the economic transaction have confidence that the government and bank are right in their assertion, everything is fine.  If those participants lose confidence a fiat currency loses some or all of its value.  Most governments require that their fiat currencies are accepted to settle any debt.

Rudy’s Recap: If you hold something that is actually valuable, say a gold coin, that’s called a Commodity Currency. If you hold something that represents something valuable, like a carved stick that represents a gold coin, then that’s called a Representative Currency.  A fiat currency is a piece of paper that is worth something because the bank says it is.

The transition from commodity currencies to representative currencies

Initially most currencies were commodity currencies.  We’ll assume coins made from precious metals though historically speaking just about anything with mutual value (a commodity!) was used as a commodity currency.  It’s great to know that what you have in your hand is actually worth something.  Gives you lots of confidence in it!

If you’ve ever carried around a few thousand pennies you realize that this stuff is heavy. Pretty darn heavy in fact. So consider the fact that ‘back in the day’ you might be running around with coins made from pure precious metals. This could get downright heavy, leading to treasure chests and the like which were somewhat difficult to deal with on a day to day basis and were often pretty easy to steal. While Captain Jack Sparrow was particularly pleased with this, your average joe wasn’t. As early as the 6th century people began printing bank notes on paper, cloth, yak hide, etc.

These bank notes truly represented the gold that could now sit in vaults instead of being carried around. This helped early economies really take off. Paper money is easier to transport, easier to loan, all sorts of good stuff. The problem is that you have to have confidence in whoever was issuing the note. If you held a 100 Yak Clipping note from the First National Bank of Yakville, you AND everyone else had to be confident that the bank actually had 100 yak clippings for you if you ever wanted to turn in that note.

Somewhere along the line people realized that there really wasn’t anything preventing the bank from printing TWO (or more!) 100 Yak Clipping notes and hoping that only one of you came to get the yak clippings. This made people be rather suspicious of bank notes and the like. It didn’t help that governments often let anyone who kissed enough behind to print their own money. Enter Chaos!

Here comes the central bank!

So to address these concerns some clever folks came up with the idea of a central bank. Put a bunch of gold in a vault and they were the ONLY ones who were allowed to issue coins or bank notes for a given currency. These notes were then considered Legal Tender – Good for all debts, public and private. The bank could decide how much currency it would issue per unit of gold it held.

This was a good thing for a long time. Either you had hard currency (a gold coin) or a gold standard based bank note (a bill backed by a gold coin in a vault at the bank). There was just one problem. Pretty soon people printed too much money and couldn’t be backed by gold. So much for a gold standard backed representative currency. Enter the concept of Fiat Currency.

And here you thought Fiat just made cars…

Fiat currency is worth money because the government says it’s worth money. It’s not backed by any sort of commodity. This means you can’t take a $100 bill and get a $100 gold coin from the bank. Fiat currency is VERY dependant upon confidence. It’s a worthless piece of paper unless you and the other side of your transaction have confidence that it’s worth something.

Since fiat currency has no backing other than faith and credit it is extremely vulnerable to inflationary cycles. Inflation happens when the money supply increases too rapidly. If the money supply increases more than the GDP does, you usually get inflation. You can also get inflationary pressure if confidence drops. Danger Batman!

So why did we drop the gold standard?

Good question! Some people claim it was inevitable. They claim that since the supply of gold on the planet is finite, there’s just not enough to go around to cover the money supply. Apparently they forgot they can just turn off the printing press. In any case, that’s the logic behind what happened, right or wrong. History hasn’t been particularly kind to fiat currencies and it’s not looking too well at them today.

Another reason why the gold standard got dropped is that governments across the world issued too many bank notes and too many debt instruments to be able to continue backing them with gold, even on a fractional basis.  By dropping the gold standard you can just print new money willy nilly and pay off your debts with funny money.

I think the biggest reason why the gold standard was dropped is related to control. If you have a 1oz gold piece you know that it’s worth something. As a finite resource it has inherent value. YOU control that value and you know that someone else can’t wave a magic wand and devalue that gold coin. With fiat money the central bankers can arbitrarily choose to add more money to the system here and there. They control the value of the $1 USD note. The more money that’s in circulation the less every dollar is worth. It’s a vicious cycle. And you and I are at the whims of the central bankers. Not a happy place to be.

So what’s next?

Monday I’ll have another article for you guys to read describing the death of a fiat currency: Hyperinflation. I’ll cover deflation in that article as well. I hope you all come back to read it!