Most people hear that inflation is causing gas prices to rise, the stock market to go up, food prices to climb…but too many people do not know what inflation is or where it comes from. This post is intended to be a simple explanation by example of how our Federal Government and The Fed create inflation, and why.
Meet the Islanders
Assume there are three people on an island; Mish the Fisherman, Chuck the Chair Maker and Hugh the Hut Builder. If Mish wants to trade his fish for a chair from Chuck so he can sit down, they have to agree how many fish a chair is worth. When they agree on an amount, they trade that amount of fish for some agreed upon amount of chairs. This is a barter (trade) economy. Most start this way.
Barter economies have limitations. For example, if you wanted to buy a car and your current job was making donuts, just how many donuts would you have to trade to buy a car? And honestly, would someone selling you a car really want that many donuts? This is why barter economies eventually move to currency based economies. What is a currency based economy?
A currency based economy is where we all agree on using something besides what we each make or do, to represent a fixed value. It should be something that is hard to duplicate, hard to find, and hard to destroy. This is why for centuries gold has been used as currency. Everyone wants it, it is hard to find or destroy it, and it can’t be copied. This makes gold an excellent store of value. The question then becomes, how much gold value is in a fish, a chair or a hut?
Back to the island. Mish the Fisherman has completed his trade with Chuck the Chair Maker. Now Hugh the Hut Builder comes to Chuck asking to buy a chair. Hugh wants to pay for the chair with fish that he had gotten last month when he traded a new hut for fish with Mish the Fisherman. But Chuck the Chair Maker just traded a chair for fish from Mish, so the last thing he needs is more fish, and he already has a hut. At this point, a barter economy falls apart as the two parties cannot agree on something to trade that is of value to both people.
But then Hugh the Hut Builder remembers that just last week he had built a third hut for Mish the Fisherman who paid him with five gold nuggets instead of fish. So Hugh asks Chuck if he will take one gold nugget for four chairs. Chuck wants to make sure he can use the gold nuggets for trade if he accepts them from Hugh, so he asks Mish if he would be okay getting paid with gold the next time Chuck needs to buy fish, and Mish the Fisherman says, “No problem at all, Chuck.” So Chuck, realizing now that gold is widely accepted since he can use it later to buy fish, accepts one gold nugget from Hugh in exchange for four chairs.
The following week, Chuck the Chair Maker finally gets hungry and uses one gold nugget he got from Hugh to buy 20 fish from Mish. When gold is a currency, the value of the chairs, hut and fish are fixed. One gold nugget will always be worth 20 fish, four chairs or 1/5 of a hut. By extension, five gold nuggets gets you one hut, 100 fish or 20 chairs. This is a fixed currency without inflation. This is a currency that everyone will always accept because it is accepted by everyone. Each gold nugget represents a fixed store of value and the measurement of that value is determined by the two people engaged in the exchange transaction and their knowledge of all their previous transactions, and what was acquired in those transactions, using gold as money. I will explain in the next section known as, The Complex Thought.
Warning: The next brief paragraph involves a complex thought….read accordingly…
The Complex Thought Begins Here
For example, you and I know what $5 can buy you. It can buy you a decent beer, an extra value meal from McDonald’s or a cheap gas station car wash. By extension, an extra value meal from McDonald’s is therefore equivalent in value to a decent beer or a cheap car wash. In other words, in a barter economy, you could trade an extra value meal for a decent beer or a cheap car wash and both parties would agree on that as a fair exchange, even if you had never seen a $5 bill in your life. However, since you and I have previously seen and used $5 bills to buy a value meal and a decent beer, and many other things, if someone tried to sell us a thumbtack for $5 we would know that is not a fair exchange even if we had never bought a thumbtack before because we know based on all of the things we have spent $5 on previously, that we would not be willing to trade an extra value meal or a decent beer (both being equivalent in value to each other and to a $5 bill) for a thumbtack. This is how gold becomes a fixed store of value. The fixed part is what we know it is worth based on what it was worth for previous things.
The Complex Thought Ends Here
This answers the question as to how much gold a fish, a chair, a hut or anything else is worth in gold. It is worth what everyone agrees it is worth.
That is why…gold is money.
Meet Barnaby Barnacle (played by Ben Bernanke)
A new villager comes to the island. He does not make chairs, build huts or go fishing. In fact, he doesn’t produce anything so he has nothing to trade. He’s quite lazy, in fact. His name is Barnaby Barnacle. Barnaby Barnacle collects pebbles from the beach and paints them with gold-colored paint. They are not real gold…they are just painted that color.
Barnaby comes to the village with two gold colored pebbles and asks Hugh the Hut Builder to build him a hut. Hugh, not realizing the gold-colored pebbles are not real gold nuggets, tells Barnaby that one hut costs five gold nuggets. Barnaby says, “No problem” and leaves. Barnaby heads down to the stream where there are millions and millions of pebbles and gathers up three more, paints them gold, and goes back to Hugh. Hugh accepts Barnaby’s gold-painted pebbles not realizing they are not real gold nuggets and builds Barnaby a hut. Barnaby then goes to Mish the Fisherman and buys 20 fish, then to Chuck the Chair Maker and buys four chairs. Every time he does this, he goes back to the river, paints as many pebbles as he needs with gold paint and uses them as payment.
A few weeks go by and one day Chuck the Chair Maker and Hugh the Hut Builder go to Mish the Fisherman for more fish, but he has none. Mish tells them that Barnaby has been buying them all up as he just loves fish and can never have enough, and remarkably, he is getting quite fat on fish which nobody ever thought was possible for anyone. Chuck and Hugh are concerned because they are getting hungry and need some fish. Mish tells them that if they are each willing to pay two gold nuggets instead of one for 20 fish, he will make sure to keep some for them. They have no choice as they are very hungry, and so agree to pay the extra gold nugget. Besides, Barnaby has been buying so many huts and chairs from them that there are lots of gold nuggets to go around for everyone (most of them are only gold-painted pebbles, but nobody realizes it).
In fact, Barnaby bought so many chairs and huts that when Hugh goes to Chuck to buy chairs, and Mish asks Hugh for another hut, Chuck tells Hugh he is out of chairs and Hugh tells Mish he is out of huts. Barnaby has bought them all. Chuck tells Hugh if he is willing to pay twice as much for the chairs, he will sell him some before Barnaby comes to buy them, and Hugh tells Mish if he will pay twice as much for a hut, he will build him one before Barnaby asks for another one. Both Hugh and Mish agree to pay more to get what they need. This is inflation.
Prices are rising for fish, chairs and huts because Barnaby is flooding “the marketplace” where goods and services are bought and sold with gold-painted rocks. The more gold-painted rocks he uses to buy things, the more gold-painted rocks everyone has to buy things for themselves. As I mentioned earlier, it is critical that the choice for a currency be hard to duplicate, hard to find, and hard to destroy. Gold painted pebbles are certainly hard to destroy, but they are very easy to find and duplicate. Because Barnaby is not using the agreed-upon currency of gold nuggets which are rare and can’t be duplicated, and is “making” his own with gold-painted pebbles from an endless supply along the river, he is able to buy up everything around him that everyone produces (chairs, huts, fish) because whenever he needs more money, he simply “makes” it. Subsequently, all of these people who are getting paid with gold-painted nuggets have so many gold-painted nuggets that when they compete with each other to buy something that has a limited supply, like chairs, huts or fish; they are willing to pay more for it because they have more gold-nuggets to pay with because they are getting so many from Barnaby.
Now who has the most to gain from all of this? Barnaby, of course! He has produced nothing of value but has simply created money by painting pebbles with gold paint and has used them to buy everything he has ever wanted. What a great deal for Barnaby! Meanwhile, Hugh, Chuck and Mish are left competing with each other with all these extra gold-painted pebbles that are driving the cost of everything they want to buy from each other through the roof! How? I explain in The Global Auction…
The Global Marketplace…aka The Global Auction
To give you another example of how this works, imagine you and two friends go to a store to buy some rare collectibles at auction. The opening bid for the first item is $50. Each of you only has $100 and you are there to bid on several different collectibles. Therefore, the most each of you can bid on any one particular item is $100, and then you’re done. As a result, each of you has to decide carefully how much you are willing to “bid up” the opening bid of $50 because your resources are limited to $100 and there are other items in the auction. As a result, this $50 item might sell to one of you for $60 or $75. Now imagine that Barnaby Barnacle, I mean me…gives you an extra $1,000. All of a sudden, each of you now has $1,100 to bid on this $50 item. Since each of you has this extra $1,000, you can each “afford” to bid up the $50 to $100, $250, $500 and beyond. Suddenly, this $50 item is selling for $750 simply because you had more money to bid on it than you did before. Was it really worth $750? No, it was not, but because each of you had more money to use, and all of you wanted this item, the cost went up to $750.
Barnaby Barnacle, by using an endless supply of gold-painted pebbles instead of the limited supply of gold nuggets to buy things is giving Chuck, Mish and Hugh an extra $1,000 like I did in the Auction example, which means they all have an extra $1,000 to spend when they buy each others limited amount of available chairs, fish and huts. So just like the $50 auction item, they drive the cost of huts, fish and chairs up as they compete with each other to buy them and have more money than they should have had to do so. This is inflation.
The Global Marketplace is much the same as the auction. Companies and countries from around the world must bid against each other, just like you and your friends at the auction, or Chuck, Mish and Hugh for each others products. But in the Global Marketplace, countries and companies from around the world are bidding against each other for steel, coal, natural gas, wheat, rice, oil, copper, pork, wood, textiles…all of the raw materials that go into making just about everything you buy. And just like the auction, the more money each of these countries and companies has to “bid up” the prices on all of these raw materials, the higher the cost of these materials become. Therefore, when these raw materials are used to make finished goods like gasoline, hamburgers, SpaghettiO’s, furniture, trash bags, dish soap, car parts, etc… the more it costs for these finished products. This is inflation.
So how do all of these companies and countries get the extra money (like the $1,000 at the auction)?
From Ben Bernanke (Barnaby Barnacle) at The Federal Reserve of the United States. I explain how in the Conclusion below…
This is exactly what is happening to the United States. Many years ago, the United States had a “gold standard” which meant that for every piece of paper in currency in your wallet, you could trade that for a piece of gold, just like on the island in my story. So when you used your paper dollars to buy something, you were really using gold, just like on the island. This kept prices stable and prevented inflation. Then one day, our Government, as all Governments eventually do, wanted more money to spend, but the gold standard kept them from having it as they could not duplicate the gold or make gold.
So over the years our politicians have removed the United States from the gold standard, first with the creation of the Federal Reserve in 1913, then President Franklin D. Roosevelt banning the private ownership of gold in 1933 and culminating in the complete cancellation of the Bretton Woods Agreement by President Nixon in 1971 so he could print money (just like the gold-painted pebbles) to pay for the Vietnam war, among other debts. In effect, Nixon said it was now legal and okay for the government to paint gold on pebbles and call it money. We know these pebbles today as the green bills currently in your wallet, and they aren’t worth much more than real pebbles.
It only took the government 58 years (significantly less than one lifetime) to quietly remove us from the financial security and stability of the gold standard and a total of 99 years to devalue the U.S. dollar by 96% through inflation…the endless manufacturing of gold-painted pebbles. If we had prevented the government from making gold-painted pebbles, this $500 iPad 2 with Wi-Fi and 32GB of memory would cost $21.74 today. Ever since The Fed was created and we were removed from the gold standard, the government has produced an annual rate of inflation change of 2,199.6%. That’s a lot of gold-painted pebbles.
Our Government continues to generate large deficits and debts because it knows that Ben Bernanke (Barnaby Barnacle) will simply print more money out of thin air (by painting gold on pebbles) to pay for it. The more gold-painted pebbles Barnaby produces and distributes through bailouts of solar energy companies, car manufacturers and banks, for Fannie Mae and Freddie Mac to support housing prices, and to “pay” for all of our social service programs, and to our banks around the country to loan out to other banks and companies and countries around the world; then the more money there is out there in the world that everyone can use when they need to buy something at the Global Marketplace (Auction).
These countries and companies with all this extra money show up at the Global Marketplace and use all that extra money (like the extra $1,000 at the auction) to bid up, and against each other, for the raw materials they need like; steel, coal, natural gas, wheat, rice, oil, etc… This makes all of these things more expensive than they should of been (just like the $50 auction item that sold for $750). These high raw material costs are turned into finished products and that higher cost is passed through to us in the form of inflation on everything we buy.
Meanwhile, our salaries do not keep up with this inflation, so we effectively take a pay cut every year as inflation destroys our purchasing power. The real rate of inflation now is approximately 7%. If you are lucky enough in this economy to still get the historically standard 3% cost-of-living adjustment after your annual review at work, you have effectively lost 4% of your income this year. If you were making $40,000 and then got your 4% increase, you are now only making the equivalent of $38,316 due to your lower purchasing power because of inflation. If we assume that you were making 40,000 in 2007, just five years ago, and received a 4% increase every year, based on the inflation rates of the past five years, you would currently have the income equivalent in purchasing power of $32,000. So in five years, you lost $8,000 in purchasing power even though you had a 4% raise every year. This is what happens when Barnaby Barnacle (Ben Bernanke) makes gold-painted pebbles to pay all of our fat, bloated Federal Government’s bills. This is also why inflation is called, “The Hidden Tax” because it allows the government to take some of your income and use it to pay its bills, without actually raising your taxes, which tends to upset people. They know if they asked you for more money in taxes, you’d say no, so they steal it instead using gold-painted pebble inflation. It’s insidious, it’s evil, and it’s what the Government does best.
The Government refuses to stop creating gold-painted pebbles, and does not care in the slightest the damage it is doing to you or your family and the debt it is creating for future generations, because it is the only way it can continue to pay for the trillions of dollars in the deficits and debts it creates to maintain all of its social welfare programs, bailouts, international loans, bloated government agencies with their generous salaries, retirement benefits and healthcare plans, and our obnoxiously large military industrial complex.
There is no end in sight to Barnaby’s gold-painting pebble assembly line and until we are willing to acknowledge that we are destroying our currency and our standard of living so the politicians can continue to give money away in exchange for votes, then we will continue to pay the price. As will our children. And their children.
In the end, this is unsustainable. As Herbert Stein once said, “If it cannot go on forever, it will stop.” When the pebble-painting and deficit spending stops, which it will do on its own, regardless of how much the politicians or the Government want it to continue or try to keep the pebble-painting going, the country will have to bear the strain of another significant economic correction that will be as bad, but more likely worse, than the one we just endured and continue to suffer through.