The common definition of inflation is “an increase in consumer prices”, and deflation is “a decrease in consumer prices.” A corollary is the old myth: “a fine suit costs the same in gold as it did in 1912, one ounce.” Why should that be? It takes less land today to raise enough sheep to produce the wool, and less labor to shear them.
Consumer prices are affected by many factors. Increasing production efficiency tends to lower prices. But today, fewer people wear a suit than in 1912, and so the suit market has shrunk. This would tend to be a force for higher prices.
I don’t know if a suit cost $20 (i.e. one ounce of gold) in 1912. Today, one can certainly get a good suit for far less than $1600 (i.e. one ounce).
Consumer prices are a red herring. If certain prices don’t change in any given year, the government claims that there is no inflation. This is a lie.
One can’t understand much about the monetary system from inside this box. I offer a different definition.
Inflation is an expansion of counterfeit credit.
Inflation is a monetary phenomenon, but it is not simply about the money supply. In a gold standard, does gold mining create inflation? How about private lending? Bank lending? What about Real Bills of Exchange?
These processes do not create inflation under gold. We must focus on counterfeiting. Gold production is never counterfeit. Nor is lending. If Joe works hard, saves his money, and gives a loan of 100 ounces to John, this is an expansion of credit, but it is not counterfeit.
It does not matter whether there are market makers or other intermediaries in between the saver and the borrower. This is because such middlemen have no power to expand credit beyond what the saver provides. Bank lending is not inflation.
At least two factors distinguish legitimate from counterfeit credit. First, someone produces more than he consumes. Second, he knowingly and willingly extends credit. He understands the terms and the risks and when he will be repaid. In the meantime, he does not have the use of his money.
Let’s look at fractional reserve banking. I have written on this topic before (Fractional Reserve Banking). To summarize: if a bank takes in a deposit and lends for a longer duration than the deposit that is duration mismatch and fraud (and the source of banking system crashes). If a bank lends deposits only for the same or shorter duration, then the bank is perfectly stable and perfectly honest. An honest bank can expand credit by lending, but it is good credit.
The saver chooses how long he is willing to lock up his money, based on the bank’s offer of different interest rates for different durations. He lends to the bank under a contract of that duration. The bank then lends it out for that same duration (or less).
Now let’s look at Real Bills of Exchange. Under the gold standard of the 19th century, a business bought merchandise from its supplier and agreed to pay on Net 90 terms. For merchandise in urgent consumer demand the signed invoice, or Bill of Exchange, circulated as a kind of money. It was accepted at a discount from the face value based on the time to maturity and the prevailing discount rate.
This is a kind of credit that isn’t debt. The Real Bill market is a clearing mechanism. The end consumer will buy the final goods with gold. In the meantime, every business in the entire supply chain does not necessarily have the gold to pay at time of delivery. This problem would become worse as business and technology improved to allow additional specialization and thus extend the supply chain with more value-adding steps. And it would become worse as certain goods went into high demand seasonally (e.g. at Christmas).
The Real Bill is self-liquidating credit that arises from consumption, and it is legitimate.
Now let’s look at counterfeit credit. Per above, it is counterfeit because there is no saver, or he does not knowingly or willing forego the use of his savings.
First, is the example where there is no surplus. A good example is when the Federal Reserve creates currency to buy a Treasury bond. On their books, they create a liability for the currency issued and an asset for the corresponding bond purchase. Fed monetization of bonds is counterfeit credit, by its very nature. When the Fed expands its balance sheet, it is inflation.
Their very purpose is to create inflation. When real capital becomes more scarce, and thus its owners become more reluctant to lend it (especially at low interest rates), the Fed’s official role is to be the “lender of last resort”. Their goal is to continue to expand credit against the increasing market forces for credit contraction.
All counterfeit credit would go to default. Thus the Fed must do more and more to avoid ending up where it’s “pay or else”. Debts must be “rolled”. Debtors must be able to borrow anew to repay the old debts forever. The job of the Fed is to enable this.
Next, let’s look at duration mismatch. It begins the same way as good credit. The counterfeiting occurs when the bank lends a demand deposit or lends money in a 1-year time account for 5 years. Both cases are the same. The saver is not knowingly foregoing the use of his money, nor lending it out on such terms and length. The saver thinks he has his money, but yet there is another party who actually has it.
Sometimes the saver does not willingly extending credit. The worker who foregoes 16% of his wage to Social Security knows that he loses his money. He is extending credit, by force. The government promises him a monthly stipend someday plus some medical coverage. It’s a bad deal, which is why they need to use force.
Social Security is counterfeit credit.
Unlike in legitimate credit, counterfeit credit is mathematically certain not to be repaid. This is because the borrower is without the intent or means to repay. It is a matter of time before it defaults (or the borrower forfeits his collateral).
Above, I offered two factors distinguishing legitimate credit:
1. The creditor has produced more than he has consumed
2. He knowingly and willingly extends credit
Now, let’s complete this definition with the third factor:
3. The borrower has the means and the intent to repay
A corollary to this is that dealers in counterfeit credit, by nature and design, must work constantly to keep “rolling” it, and to maintain the confidence game. It cannot be repaid normally. Sooner, or later, it inevitably becomes a crisis that either hurts the creditor by default or the debtor by threatening or seizing his collateral.
I repeat my definition of inflation and add my definition of deflation:
Inflation is an expansion of counterfeit credit.
Deflation is a forcible contraction of counterfeit credit.
Inflation is only possible by the use of force by governments and central banks. Whenever credit is extended with no means or ability to repay, that credit is certain to eventually become a crisis. Either the creditor will be harmed, or if he has good collateral then the debtor must take the pain.
Here’s to hoping that in 2012, the discussion of a more sound monetary and banking system begins in earnest.