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Inflation for Dummies
Excerpts from my book, Money and Wealth: A Lifetime of Learning, Book 2
Imagine two groups of people: Those on Gold Island, who have a moral conscience, and those on Silver Island, who are a mix of those with a moral conscience and those who do not, or who are mixed within themselves. They begin trading with each other. Both have created the same system of money, using gold and silver coins of similar value.
The main difference is that Gold Island money is stamped with the words “Gold Island” and Silver Island money is stamped with the words “Silver Island.”
(Iron Island bandits don’t care about trade and coins, except for those that they can steal.)
Both Gold Island and Silver Island accept the other island’s money because the weight is the same for the same kind of coin. Both islands benefit from trade. The people of Gold Island make the best fishing poles and slingshots. They have skill sets that the people of Silver Island don’t have.
The people of Silver Island also create all kinds of different tools, silks, crafts, and other goods that the people of Gold Island can’t produce.
Since both economies have grown strong, a lot of gold and silver coins get used. Some people are getting very rich. And gold and silver coins are heavy to carry. So one of the good persons on Silver Island comes up with a new idea. Why not become a goldsmith?
A goldsmith is someone who stores gold for travelers and merchants and charges a small storage fee. The idea catches on and someone on Gold Island starts a goldsmithing business as well. Goldsmiths store gold and silver coins, have hired security to prevent the Iron Island bandits from stealing it, and charge people a small storage fee.
In place of the coins, the goldsmith gives the traveler or merchant an official slip of paper that reads something like this: “Tor has on deposit with the Silver Island Goldsmith 20 ounces in gold and 65 ounces in silver. Payable on demand.”
Each note is signed both by the goldsmith and by the traveler. The goldsmith keeps a record of all transactions. The paper is an IOU note for the gold and silver coins that are stored. The traveler can now go to market and wander around town without carrying all that weight in coins.
And the traveler does not have to worry that a bandit from Iron Island (or one of the less honest people from Silver Island) will rob him or her of those coins.
After a while, the goldsmith on Gold Island has an idea. Each paper IOU note is specifically created for each person. What if the IOU notes had a more general design that is not specific to the person? The IOU note might read something like this:
“Will pay to the bearer 20 ounces in gold, payable on demand at the Silver Island Goldsmith.”
What if the goldsmith created different values for different notes? There would be a whole set of IOU notes. And the people could trade IOU notes with each other. In other words, the traveler can get a set of IOUs from the goldsmith:
Four notes would be for 5 ounces in gold, three notes would be for 10 ounces in silver, five notes would be for 5 ounces in silver, and ten notes would be for 1 ounce in silver.
The traveler can go to local merchants and trade the paper notes for goods and services. The merchants know that they can always go to the goldsmith and receive the gold and silver coins. The goldsmith charges a small fee for each storage transaction. And everyone is happy.
Now here is where everyone’s understanding of money begins to break down. Pay close attention:
The paper notes are not money.
Paper notes are IOUs. Paper notes are symbols of money. Paper notes are NOT money. We will be exploring what less-than-honest people on Silver Island can do with paper notes in the chapter on Inflation.
For now, let’s see what other good things can come from the honest people on Gold Island.
* * *
“…banking establishments are more dangerous
than standing armies…” –Thomas Jefferson, letter to John Taylor, May 28, 1816
Thomas Jefferson obviously makes a strong statement about banking. Let’s talk about what can be good about banks run by people with a moral conscience and who believe in free choice.
When real money is saved, when wealth is saved, it can be used to do good work. How? By making money available for capital investments.
The goldsmith on Gold Island (the model island where everyone has a moral conscience) has a thriving business. Everyone trusts him. He stores people’s gold and silver, charges a reasonable fee for the service, and protects their money.
They have found the paper notes convenient to use for trade, and they can get their money from the goldsmith any time they want.
Time passes, and the goldsmith notices something. No matter how many transactions he has every day, the amount of gold and silver never falls below the equivalent of 100,000 ounces in gold.
The goldsmith has an idea. He could loan some of that gold to Tor, who wants to expand his fishing rod business. Tor has all kinds of ideas about how to make fishing rods, nets, lures, and all other fishing equipment in faster and more efficient ways. He just needs some money.
So the goldsmith and Tor talk with some of the depositors who use the goldsmith’s service. They have an idea that will make everyone money. Tor will borrow 10,000 oz. of gold for six months. He will pay it back with an interest rate of 1%. In other words, he will pay back 10,100 oz. of gold for the privilege of borrowing the gold.
Two depositors agree to allow the goldsmith to loan 5,000 oz. of gold from each of them. In return, each depositor will get 45 oz. of gold (a total 90 oz.), and the goldsmith will get 10 oz. of gold for making the arrangements.
Everyone understands they are taking a risk. Tor’s idea may not work. Something may happen that will make it impossible for him to pay back the gold.
But everyone thinks the risk is worth it.
Tor borrows the money, hires workers (creates jobs), creates new products (creates wealth in the form of capital goods), and his business takes off. After six months he is already making more than 100 gold oz. each month.
Tor easily pays back the loan, plus interest. Everyone makes money by making the saved money do extra work. The risk paid off.
Now the goldsmith has become a banker.
* * *
“All the perplexities, confusion and distress in America arise, not from the defects in their constitution or confederation, not from want of honor or virtue, so much as from downright ignorance of the nature of coin, credit, and circulation.” —John Adams, letter to Thomas Jefferson, August 28, 1787
When everyone is honest, bankers, government workers, wealth creators, and taxpayers all benefit.
But what happens when people are less than honest? Let’s follow the thinking of the goldsmith on Silver Island, who sees things just a little different from the goldsmith on Gold Island.
Like the goldsmith on Gold Island, the goldsmith on Silver Island creates paper notes (IOUs) to represent the actual money (gold and silver) that people deposit with him.
The amount of the notes exactly equals the amount of gold and silver coins he has on deposit. If there are 100,000 oz. of gold and silver on deposit, there are notes equaling 100,000 oz. of gold and silver in circulation.
How much money is there in total? If you answered 200,000…
No! No! No!
The total is still only 100,000 in money. Only the gold and silver coins on deposit are money. The paper notes are symbols of that money. Paper notes are NOT money. They are currency.
But the goldsmith on Silver Island (the island with a mix of people with and without a moral conscience) notices that almost everyone who uses the paper notes thinks of them as money. Some people almost never come to redeem their notes for actual money.
They are happy to use the paper notes for trade and payment.
Workers begin asking employers to pay them in paper notes rather than gold and silver coins. The workers know they can trade them in at any time, but why bother?
Paper notes are so much more convenient to carry.
The Silver Island goldsmith then has a crafty idea. What if he printed up extra notes? And spent them? Who would notice?
You can see how tempting it would be to the goldsmith who is normally honest, but who suddenly has a medical expense.
Remember, this is Silver Island. The people here are a mix of good and bad. Sometimes they know it, and sometimes they don’t. On Silver Island, some otherwise good people can rationalize something bad as being good.
The goldsmith’s child needs help and he is short on money. Why not just “borrow the money” now by printing up a few extra paper notes to pay the doctor? Then just pay it back later by destroying the other paper notes when he collects his storage fees? No one would know. And besides, it’s good for the child.
So the goldsmith does print up the extra notes. And nobody notices. And the child gets better. And the goldsmith pays back the “money.” What he does is a good thing, right?
As time goes by, the goldsmith rationalizes other bad actions as being good. Why not print extra paper notes to buy better food, pay someone to rebuild the fence, and get his wife a nice gift? He figures that since nobody notices, why should he even pay it back? He works hard for a living. So what if he has a few extra nice things. Nobody notices. Nobody cares.
Soon for every 100 oz. of gold stored, there are notes circulating for 110 oz. of gold.
And prices around town begin to mysteriously rise.
What the goldsmith on Silver Island does not realize, and almost everyone else as well, is this: When more paper notes are “spent” and put into circulation, merchants notice that more goods are in demand. When demand rises, the value of what people buy rises, and therefore merchants naturally charge more.
More paper notes = Rising demand = Rising prices
Supply and demand. Cause and effect. Choice being exercised in a free society.
A year later, the goldsmith on Silver Island decides to support another islander for election to the local council. Together they hatch a scheme to outspend their opponent. The goldsmith prints up a lot of extra paper notes and donates it to the candidate’s campaign. Because, you know, his opponent has bad ideas, so the extra paper notes are really a good thing, you know, for the good of everybody.
More notes begin to circulate as the candidate spends the extra notes for political influence. And prices mysteriously rise.
The candidate is elected and begins putting pressure on the goldsmith. Print up more notes so that the government can hire extra people. And spend money on community projects.
The goldsmith does. And prices mysteriously continue to rise.
Who is to blame for the higher cost of living? The politician blames the greedy merchants. And the merchants don’t know what to say. They do not understand the real cause of the rising prices. But the merchants, and actual creators of wealth, continue to be called greedy and uncaring. They do not realize that the rising prices are a natural result of the inflation.
What is meant by inflation? You know what happens when you inflate a balloon. As more air is pushed into the balloon, the amount of air increases. What increases when you have economic inflation?
The supply of paper notes (currency).
Government, and people who make a living off of debt, will tell you that inflation is rising prices, just a natural force of nature, without anyone causing it. Right?
Wrong!
Inflation is NOT rising prices. Inflation CAUSES prices to rise.
As the currency supply increases, prices are forced to rise. If you think the definition of something makes no difference, then you are a good target for con artists.
What if I can plant the idea in your mind that inflation is merely the rising of prices? I can keep you from seeing the cause-and-effect relationship between printing paper notes (or digital currency) and rising prices.
And if I can plant the idea in your mind that government debt is a good idea, then government can continue creating money out of thin air. To do what? To finance projects, wars, entitlements, and many other government “goods.”
Who pays? Workers who create wealth and become taxpayers are the ones who pay. Not the ones whose income is paid out of tax money.
The bankers and politicians on Silver Island soon tell the public that they have to withdraw gold and silver from circulation. Why? Because there’s not enough to go around, and besides, the paper notes work well as money.
And almost everyone believes them, except a few kooks who talk about some kind of conspiracy between bankers and politicians. But nobody really believes them.
[There’s more in my post on Snap Out of It, Part 3.]
Published in Economics
If you start at 36:20, that is most of what I’m talking about. I think it’s pretty hard to argue with.
If we are edging toward a digital economy and MMT, why are central banks around the world storing gold and buying more tons of gold each year?
To share among their billionaire-totalitarian friends. They know where value lies.
Meanwhile, we are asked to eat bugs. Guess who will eat steaks?
But of course the government can determine the price of labor, because a ‘living wage’ is a moral question.
God I hate these people.
You are implying that under the assumptions of your hypothetical, the goldsmith is not honest.
(These are not easy questions to think through clearly. Over the centuries, even the most prominent economists have consistently gone astray in the same way when they argue about banking because they fail to do so.)
Unlike fish, that could be eaten or go bad.
Which is part and parcel with it’s stability.
My husband and I have a moratorium on discussing the mysterious evolution of gold into money. Why? We keep getting into blow out fights about it, lol.
I think I understand why gold. He doesn’t. I think the value of gold as a luxury item is a result of its value as money.
So to him, gold has no intrinsic value, so why use it as money?
I think I explain that clearly in the passage you point to. Dishonesty occurs when we break an agreement, when we do not do what we agree to do, or encroach on others or their property. We can rationalize our way into dishonesty, and it takes real discipline to follow the dictates of a moral conscience. In my view, we are all accountable for all we think, do, and say, whether we believe in that accountability or not.
Hope that helps.
He’s mistaken, in my view. But ah, the variety of life!
Shiny soft and easy to work. Technical attributes that fulfill both jewelry making and minting.
Another way to look at intrinsic value is this:
If Federal Reserve Notes lose purchasing power, no one will want those that I have.
But there are always people who want my gold and silver, for one of several reasons. Thus, gold and silver have intrinsic value.
Why do legal tender laws advance human flourishing? Or do they? lol
My question as to why central banks have been buying up gold is answered in that gold still is, the single best value over time; and indisputably the most uniform, easily evaluatable (unlike, say, diamonds with have flaws and poor quality cuts), distributable, workable, fungible, and limited thing of value in the world.
One thing that amazes me is that young people are now buying stainless steel wedding bands.
SIDE NOTE: Our founders, as many of you already know, did all they could to insert in the Constitution constraints on the possibility of printing paper “money.
Article 1, Section 8, Powers of Congress “To coin Money, regulate the Value thereof, and of foreign Coin, and fix the Standard of Weights and Measures”
The use of the word “coin” is deliberate.
Article 1, Section 10, Powers Denied to States: “No State shall enter into any Treaty, Alliance, or Confederation; grant Letters of Marque and Reprisal; coin Money; emit Bills of Credit; make any Thing but gold and silver Coin a Tender in Payment of Debts“
No ambiguity there. These are STILL the law of the land. They have not been amended. One more reason to deny students an understanding of the Constitution.
If you’re one to rationalize that these are truly not the law of the land, then welcome to massive govt debt and our path to hyperinflation.
Here’s another clue to how brilliant the American Founders were: Roger Sherman signed all four of America’s founding documents. He wrote a small pamphlet entitled: “A Caveat Against Injustice or An Inquiry into the Evils of a Fluctuating Medium of Exchange.” (PDF) (HTML)
No, Saint Augstine. You gotta forget that.
It’s an example of a common informal fallacy. If Ricochet loses our resident logician to the Siren call of faulty dialectics, where will we be?!
;-)
Note:
This particular instance of the fallacy (around the word “inflation”), which I call the “Reification of Words” fallacy, is very commonly heard in Austrian circles, both among amateurs posting in forums and even among many authors.
It can (I think) be traced back to a particular text (a perfectly valid text) by Mises that was subtly misinterpreted. He was complaining about the damage done to the clarity and expressiveness of the conventional glossary of economics by the sudden and permanent semantic shift, shortly after WWII, from “inflation” meaning “monetary inflation”, to it referring to “price inflation”. Today, if an economist wishes to use “inflation” to mean “monetary inflation”, it is incumbent on him to used the latter phrase.
As is often the case, the misunderstanding was simply passed from one writer to another until it hardened into conventional wisdom.
The fallacy being to think that the meaning of words can’t change?
There’s a good Dilbert about that. I hope I remember to look for it later from the office compy. Too hard on this here phone.
That’s a clear answer to the first question.
What is your answer to the second?
Yes, the meaning of words change. What I am pointing out is that there are cases where con artists WANT to change the meanings to obscure accountability and cause and effect.
When taxpayers can recognize that govt can inflate currency (to print “money”out of thin air, to spend on parties or to line the pockets of powerful friends), which can cause prices to rise in certain circumstances, taxpayers can hold them accountable.
But if those profiting can change the meaning to “inflation is rising prices” then they can blame others, or simply say that it is a natural occurrence, with no clear cause-and-effect relationship between rising prices and govt action.
This is not hard to grasp.
The goldsmith printed up fake notes. The dishonesty is evident because if his patrons knew he did such a thing, he would lose their trust. They may understand why he did it, but he could have requested the help and maintained trust.
A further point: When you see dictionaries start to change the definition of inflation to rising prices but no longer mentioning the increase in currency supply, you have more evidence of corruption.
As you well know, the key to corrupting thought is to corrupt language.
Classical Economics was a failed attempt to build a consistent theory of economics on the basis of your theory, called Intrinsic Value Theory.
Inherent Value Theory is called that because value is thought of as a property inhering in the object valued.
In Subjective Value Theory, value is thought of as a property of the Subject–the person valuing the goods–not the thing valued.
The revolution allowed economists to develop for the first time a comprehensive, internally consistent theory of economics. No economist of any school today accepts Inherent Value Theory.
Perhaps if you revisit Classical Economics you can find a way to revive Inherent Value Theory and succeed where the Classicists failed. I encourage you to try. That is what scientific inquiry is all about.
The fallacy being to use a definition as a factual premise in a dialog. An indicator of the use of this fallacy is when the argument contains an assertion about the “correct” or “incorrect” definition of some verbal token. The argument implicitly assumes that a definition (like a fact), can be true or false.
Is there something else one can do when one’s opponent doesn’t use a word according to its dictionary meaning, or believes something that would render the dictionary definition false?
E.g., thinking omnipotence means ability to do anything, even though the ability to fail, lose, die, etc. requires weakness. How is one to respond without spelling out the dictionary definition as a premise–that omnipotence is unlimited power?
Yes. In this case, as in every other, always follow Camp’s Modestly Named First Law of Dialog.
If you want a meaningful answer, start with a meaningful question: ensure that all parties to a dialog are
See Camp’s First Law of Dialog (the modestly named one). It can be obeyed in any of these four distinct ways:
Your question was in the domain of Rhetoric, but I didn’t give an answer in that domain, but rather in Dialectics. That’s because regardless of the motive of the person giving an argument (honest, or sophistical) one can responds as if his motive was pure.
The motive of the post-war Keynesians in redefining “inflation” was undoubtedly deceptive: they were using sophistry. Avoiding rational debate with Mises was their best political strategy, given that they had already lost the rational argument.
But Mises didn’t attack their motives. He just said that they had removed the accepted definition of a needed technical term (“inflation”) and provided not suitable alternative. He was being polite.
I suppose if I tried harder and intentionally began with this stuff and made a point of taking only one baby step at a time, maybe this would work.
But I’m not very optimistic. I’ve known an arguer to cite the same dictionary definition I’m using and then go on to abandon it. I don’t know what else to do other than keep laying out the facts–including his own citation.
Rhetoric makes impractical what dialectics suggests: beginning with agreement and proceeding by baby steps. I don’t promote that because we are always struggling against rhetoricians, whose values are often in conflict with the ends and means of dialog (true knowledge about a subject, and facts and logic, respectively). People don’t like thinking and will only tolerate it for a short time. Progressives don’t like truth to begin with.
The practical approach to applying that one guy’s “Law” is reactive, not proactive. Presumptively use the most plausible of the dictionary definitions and implicit assumptions, and assume the other guy is doing the same. When you see that a point turns on a hidden definition or assumption, raise it at that time.
The ability of two people to engage in meaningful dialog is limited by the intelligence of the less intelligent. Neither dialectics nor rhetoric can overcome that fact. I feel your pain.
I think you’d have had trouble telling who was the less intelligent in that exchange. :)