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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
Well, I kinda like you.
I definitely deserve some of it.
Specifically, what I mean is, people don’t get how the Fed and the financial system screw over the possibilities for conservatives and libertarians. Nobody gets it.
Well, as you suspect, I get it. It’s akin to the difference between scientists and engineers. Theory v. Practical application. The Richard Feynmans of this world are rare.
Check out 1:04:00, as well.
There’s some good stuff in Proverbs too.
If you do an internet search for “inflatable dummies” you mostly get links to places that want to sell you inflatable mannequins.
Debt is slavery. The debt to GDP goes up to uncontrollable levels. The whole planet. I swear this comes from discretionary central banking. Inflationism.
Mark Alexander,
These are your answers to the two questions I asked, which are necessary to establish a valid dialog.
Mark, if we don’t have the same system of moral beliefs, then our dialog is concluded without agreement. Each of us presumably has a valid argument: For me, “fractional reserve banking is moral”. For you it is dishonest.
I defer for now the proof that the irregular deposit contract is not dishonest.
* The “kind and quantity of goods tendered” is what ancient Roman banking law called the “tandendum“.
** Roman Law called a so-called “deposit” of fungible goods, an “irregular deposit”.
Unlike the goods in a regular deposit contract, fungible goods cannot be identified, so it is meaningless to speak of those goods being returned. The fungible goods are commingled with other stores (accounts, if you will) of the same kind.
You have shifted the core issue. What I addressed has nothing to do with reserve banking. What I framed maintains that the gold and silver on deposit equals the paper notes.
It is the act of printing up notes BEYOND what exists, creating an imbalance, that introduces a moral (or perhaps more accurately, an ethical) issue.
By fractional reserve banking, I mean a bank “printing up notes beyond what exists” in the bank’s stores of base money.
So you and I are discussing the same core issue.
No, we are not.
Let’s try a reset. I posted the introductory chapter of the book to demonstrate the context within which I was presenting. Helping people understand the basics, one step at a time.
There are always people who want to multiply the issues, which leads away from clear understandings. (This is what happened with My Shakespeare Confession. The issue is complex, and the only way to secure agreements along the path to understanding the larger case is a piece at a time. I tried this with one member, attempting to focus on one issue, the writer’s knowledge of law, which does not directly address authorship. But that person responded with multiple issues, often a sign of little real interest in being persuaded, or often an inability to get past ideological beliefs.)
There is a world of difference between a goldsmith who is simply paid to store and protect gold and silver, and a goldsmith who honestly secures agreement with the community and customers to invest an agreed-upon portion of the holdings into a beneficial community project, for example, with attendant risks and potential “interest” for depositors.
And all of that is a long way from any discussion of the inflationary reserve banking YOU are introducing.
My goldsmith is NOT engaging in that. He is deceptively, without the agreement of his depositors or larger community, creating false notes for personal gain.
That is wrong, and is the first step into the kinds of self-justifications that come later, justifications that easily attract the morally corrupt and lead to where we are now—tens of trillions in debt that inevitably destroy an economy.
Our founders understood the dangers. They tried to constitutionally prevent it. They failed.
I don’t think debt is slavery in any meaningful sense. One could make a case that all promises and obligations are slavery, I suppose, but that broadens the definition of slavery to the point where it’s useless.
Discretionary central banking is a problem, of course, especially as now set up.
My book is talking to one person at a time about how debt works in an individual’s life. It’s the beginning of making the distinction between living on the debt side of life or the asset side.
Con artists want you to believe that a life of continual and increasing debt is good.
I should have put “Debt is slavery” in quotations because I was referring back to how it was set up in the article. Debt is great as long as it used to increase productivity or something like productivity. Obviously our system is not set up like that anymore.
It seems to me that we are discussing only two simple ethical issues, both of which you raised.
You named two kinds of promise made by goldsmiths:
You implied, as I understood you, that one of them is unethical (or both). I said that neither is.
There is also the fact that even though gold is fungible, the IOU does represent an actual deposit of gold. If the goldsmith can issue IOUs without a deposit, then why can’t anyone else? And if anyone can issue unbacked IOUs, then trust in the system of IOUs immediately breaks down. It is in that destruction of trust that the ethical lapse lies.
Are you confusing an IOU with the obligation of a true deposit-holder?
If you hold my IOU, you have title to that IOU, and nothing more: nothing that is in my possession. If you hold a deposit receipt, you have title to the goods I am holding: the identifiable goods if that is what was deposited, or of an equal quantity and quality of goods if that is what was deposited.
If I hand you a simple IOU for a cup of sugar, what do I promise about some actual deposit of sugar?
If you think carefully about it, I think you will agree that I have promised nothing about such a store: if I had, it would be mentioned in the note.
This is an extremely difficult distinction to grasp, but I encourage you to think about it. Until you do, you can’t answer Mark Alexander’s question correctly: are a banker’s promises dishonest?
If a goldsmith can issue IOUs without a deposit, then a child on the playground could issue an IOU for a sandwich without a deposit. A young couple could issue a mortgage IOU without having the money on deposit to make thirty years of payments. A kid could issue an IOU to cut your grass next Saturday without it being Saturday.
I hope you can see from these examples that an IOU has nothing to do with any deposit.
If anyone can issue IOUs without any backing but his promise, then the system of IOUs does NOT break down. You have the system exactly backward. An IOU isn’t made in the absence of trust.
I used IOU because you used IOU. I don’t care what you choose to call it. If you’re handing out pieces of paper that you say can be exchanged for gold, and you don’t have any gold or resources to acquire it, that is fraud.
***I AM GOING TO REGRET THIS***
The other dimension is, they force you to pay your taxes and debts at gun point with the IOU.
Also, did you know that if you throw a bunch of Mongolian tögrög in a safe for a few years and it goes up and you trade it for the United States colored pieces of paper that they force you to use to pay taxes and extinguish debt, they tax the crap out of you?
***WHY IS THIS SO…DIFFICULT*** #TheRulingClassSucks
WHY DO THEY DO THIS COMRADES? #GOSPLAN
Yes, I think gold is mostly fungible. Not all gold is bullion. And even if the gold is held on deposit for safety reasons, it may be historically significant, significant in it’s trace elements, or may be quit easily worked into jewelry or other items, but still registered only as it’s weight of gold content. Otherwise, markings can prove ownership.
Iirc, the gold that was repatriated to Germany was melted down and restamped, likely to obscure its most recent source.
If I borrow and give an IOU for a Renoir, the IOU is only for the Renoir, not any other Renoir. Gold can have such significance of identity as well.
I surrender.
For simplicity we speak of fungibility as if it were a binary-valued, inherent attribute of the concrete thing.
But you bring up a truth that we should keep in the back of our minds. From the point of view of sound economic science (“praxeology”), fungibility is a variable that only applies to a specific human action, not to a class of concrete goods. In a given exchange, a class of goods that is usually considered as fungible, like corn, gasoline, gold, or even Federal Reserve Note money, may be mostly non-fungible: bagged gold or serialized coins or paper money can be non-fungible, and in that case, it is logically possible for two people to enter into a regular deposit contract.
I sympathize. The dialog on “is modern banking ethical?” is exhausting.
I hope that this conversation has at least made you question your views. The ethical corruption of America’s banking and monetary governance is proving fatal to our country, so understanding the issue is critical for voters if we are to reverse the trend.
I’m disappointed, but not too. I have been involved in countless dialogs on this exact ethical question, and can think of only one that was resolved successfully! Ironically, that one case was a conversation with Frank Shostak, a staff economist at Mises.org. We agreed that banking of the kind we were discussing is ethical.
I say “ironically” because Frank was at the time a staunch defender of Murray Rothbard’s view that modern banking is unethical, and as soon as he expressed his agreement that it is ethical in a private email to me, he returned to his original public opinion and has never again varied from it.
I think that one case of momentarily successful dialog may be why I keep trying. I also hope that I have at least gotten people thinking critically about the question, maybe for the first time.
I don’t think I can find the exact discussion where I was trying to explain that the only thing they can tax is inflation. They can’t tax you increasing your lifestyle with better purchasing power. So they are going to force inflation for that reason among others. This is a great article that relates to that.