There Is A Huge Amount Of Invisible Inflation

There are two things in finance on my mind lately. Inflation and Crypto currencies.

This article will be about inflation. Check back later today for one about a hidden risk in crypto.

Bear in mind that what follows is not the work of an economist but rather someone who is trying to use common sense. The common sense in this is you cannot get something for nothing.

Let’s begin with the idea of money.

Everything is still barter

The economy is still a barter idea. The distinction from ancient times is you don’t have to trade directly with someone who wants what you have in the right proportion to what you want. Ten fresh-caught salmon for a buckskin jacket is cumbersome and the wants must coincide both in amount and in time. I am sure the jacket makers knew their jacket would be worth about the same three days from now. You as a provider of fresh salmon, were more motivated to be rid of them. Maybe eight would have been a reasonable price.

Money makes the barter system work better. You can trade your salmon today to someone who can use them now, possibly a seafood restaurant or a manufacturer of fine smoked salmon. You sell them for your best price because they’re at their best. You don’t get the object you want though. You get money.

From there, you take your money and visit the jacket maker and trade your money for it. You don’t need to hurry because the money won’t go bad by Friday.

Money is a very handy thing. 

Money provides three values.

  1. It allows barter to happen without a coincidence of purposes.
  2. It can be stored.
  3. It allows the idea of a price. Ten salmon is not very specific while $10 is. You could shop around.

The problem is – What’s money?

In the beginning it was anything scarce. From seashells to gold. The idea was it had value by reason of scarcity and desirability, and was not particularly useful for anything else. We have seen how that works. In the recent past, silver came to have value for other things, primarily electronic. Melting silver coinage became an advantage,and it was not long until those coins disappeared entirely.

In a perfect money world, the money should be totally useless for any other purpose.

When that happens you must have an authority who does two things.

  1. Use their place to “back” the currency they create, and
  2. Keep it scarce enough.

The risk is in keeping it scarce. At least relatively scarce. As the economy grows there will be more transactions and because a given gold coin can only be used one at a time, the economy might be limited by a currency scarcity. The ruling authority can make that problem disappear. They can create paper money. In the beginning it would be backed by gold or silver but that tends to not last long. The result is fiat currency, money because we say it is.

Do you suppose some government might say to themselves, “Gold is limiting, but  we can create more money so long as we have ink and paper.” I suspect that feature was discovered very early on. Today it is even easier. You don’t need ink or paper even , just a computer to create a balance in someone’s account. They print a bond, and you give them access to spending money.

Suppose your children wanted more money and you did not want to raise their allowances. How fast would they create IOUs if you would take them as worth money?

Inflation helps sometimes.

Sometimes inflation is important. Economies respond to money and in emergencies making more available can help. Economies don’t respond to extra money as quickly as the government could create it, though. Eventually the price level rises. Not a problem if the creator sops up the extra money they created before the economy catches on. In simple terms – run budget surpluses and buy back the bonds (IOUs) you created to formalize the extra money.

Galbraith talked about a similar thing. The bezzle – a condition where someone has stolen from you and enjoys the proceeds while you don’t know of the loss and still feel good about your wealth. The same money rewards both of you while in reality only one. There is no crime if you return it before people know it is gone.

Eventually all governments use inflation to accomplish their delusions. It’s free money from their side. They sell bonds to people for money and spend the money. The really fine trick is the people who gave up their money become responsible for paying back the principal and interest.

Simple question. Where does government come from?

It is little more than this.

  1. Give me money for this impressively printed piece of paper.
  2.  I will spend the money to suit my purposes
  3. The bond or interest is due, give me money to pay it, or more likely Your taxes are due.

You can see how that might be attractive to the rulers.

The risk is inflation is addictive

James Callaghan, a British Prime Minister in the 1970s sums up the risk. “In the beginning, inflation has quick and positive effect, but it is like heroin. As you use it, it takes more to get the same effect. Eventually the margin between what works and what will kill you becomes very tiny.”

Where have we been  with inflation?

Inflation is not an ever-growing condition. I looked up Federal Reserve Economic Data for the amounts over the years from the beginning  of 1947, where the file begins, until the end of September 2021. While it misses two world wars and the great depression, I thought, “Okay, those are times of other problems and may not make the point.” I think we might have learned something useful about government overreach from the 1930s but that is not the problem for today. Inflation by the month is highly variable which would indicate that it is not entirely a monetary issue. If the Fed prints money this month it will be months before it shows up in the economy.

You can look at inflation in two ways. One is the percentage change in purchasing power year over year. That is essentially a useless idea because it is too abstract. Worse it is not a number big enough to attract immediate attention. For example, the inflation in the month of July 1948 was 0.12%, while in March of 1949 it was just 0.04%. Despite being just a third of what it had been I doubt anyone noticed the difference.

A better idea is the price level, which is the amount of money it takes to buy some basket of goods compared to to what it would have cost to buy the same basket at some reference point. In this case it looks like mid 1983 is the reference point.

At the reference point the basket cost $100.10. That is a more concrete. Five $20 bills would buy this basket of goods and services. Looking back and forward from there I learn that in march 1971, twelve years prior, two $20 bills would have been enough and in January 1947, I would have need barely more than one. It seems that in the 36 years from 1947 to 1971 the money dropped in value by half. In the next 12 years it fell by 60% more.

Of course, 1971 to 1983 was explained away as an oil shock and the war in Viet Nam and a dozen other incidentals. The reality was they printed a lot of money rather than let the market adjust on its own.

In the 1930s, Will Rogers opined that what the country needed was a good 5-cent cigar. It has come to be that what the country needs is a good 5-cent nickel.

The problem did not go away as we accepted OPEC and the war ended. Their is always an excuse to print more money and it usually involves hiding a mistake, or gathering power. On October first 2021 what in 1947 cost a bit more than one $20 bill costs slightly less that fourteen $20 bills. Over the entire period, the price level rose from $21.48 to $276.73.

There is one comfortable advantage. It makes me think I am stronger now. At one time it was all I could do to carry $30 worth of groceries. Today, I can do it with one -hand.

Will inflation get worse?

Just now the government is making noise about the supply chain problem and it being the cause. It likely has some effect now, but it will go away. If the government is right in their talking point that it is transient, we’re okay. If that is not the cause, then what?

The question is did printing money create an opportunity for inflation to appear and for some reason, it has not yet happened? I think so. Why?

Price level is created by transactions. What if they created a lot of money, distributed it in the economy, but over the entire population, it was unspent? The price level wouldn’t change much. There would be no auction as people competed for scarce goods by offering higher prices with their newfound money.

People who don’t spend suppress inflation.

Velocity of money

There is another factor involved – the velocity of money. That’s how fast money turns over. If I buy from you and you buy from someone else with that money, then the money has turned over twice. Two transactions. That’s about the normal historic rate over a year.. Since the beginning of 2007 or so, it has been much lower than two times. It is now about 1.1 times.

Relative to the money available the value of the money turning over is barely more than half of normal.

The Fed provides a useful graph

M2 referred to is the idea of money. It includes cash and coins, plus balances in chequing and savings accounts, plus money market funds, and term deposits less than $100,000. To get M2SL which is the more recent version, deduct any of those amounts held in retirement accounts. Think of it as spending money in the economy.

There is an interactive Velocity graph here. https://fred.stlouisfed.org/series/M2V

Why did the turnover fall sharply? Because people were, and are, afraid. The future is less clear than it was. When you are afraid, do you cut back some and put money away for troubled days. Of course you do. If everyone does it at once, the velocity falls.

Let’s see the other side of the question

The M2 money supply

From the 30,000 foot level, twice as much “money” turning over half as fast looks the same as neither changed. Behaviour made it look like less money was created, even though M2 grew greatly. Again the Fed helps us see it.

The interactive version is found at https://fred.stlouisfed.org/series/M2SL

Notice how the line has grown quickly in the past quarter century.

So what does it mean?

From the beginning of 2007 to September 2021, M2 grew from $7.070 trillion to $20.989 trillion

Velocity fell from 1.997 times to 1.1125 times.

If I create an “effective money supply” as being actual M2 times velocity I get this. (I have assumes it takes about a year for the effect of the money to show up. So for the 14 years from the beginning of 2007 to the end of 2020 we get this.

  • M2 x V at the beginning of 2007 =7.070 trillion x 1.997 = $14.119 trillion, effectively.
  • M2 x V at the end of 2020 = $19.130 trillion x 1.134 = $21.693 trillion effectively.

The effective money supply grew by 2.78% annually over that 14-year stretch. and inflation recorded for the period end of december 2006 to now was 2.17% . I thought it would be closer. Probably the time to show effects is different than 9 months. Or there could be another factor I don’t know about. Help from real economists would be welcomed.

Where that thinking leads

What if M2 is right and velocity suddenly becomes 2 times a year. The the effective money supply at the end of September 2021 would have been 20.989 x 2 = $41.978 trillion and the growth rate from the beginning of 2007 would have been 7.7%.

We could assume that roughly 5% a year of inflation has been suppressed by the decline in velocity.

If the economy adjust to velocity of 2 that inflation will appear.

What should we expect?

Nobel laureate, Milton Friedman was a strong proponent of monetary effects. If M2 goes up, there must inflation and if there is not, it must be because the effective money supply, the one that appears in transactions, must have been about the same. Effective money supply is what matters. To keep effective money supply lower, velocity must be low. To achieve that we must have either more fear and uncertainty to keep the effective supply down or the government has to sop up the surplus by more taxation. Neither seems attractive.

Further, given they clearly intend to run massive deficits over the near future at least and thus add to M2, we should expect more inflation even as we are taxed and as velocity stays low.

What if there comes a new government that restores confidence and reduces unproductive taxation. While that sounds like a good thing, they will look foolish for having done it. Optimism and the people keeping more of their money, creates a problem of perception. There is a huge amount of baked in inflation because of underused money. That will push prices and they will be blamed for it. How long could they work their program if inflation was 10% or more a year during their term? One term is my bet.

Deep political thinking involves reality.

The left has learned a fundamental lesson. You cannot govern all the time, but you can govern most of the time. The trick is to do what you want when in power and then lose an election as the house of cards collapses. The “winners” appear to be totally incompetent even if governing effectively.

People notice gas  and food prices, but they don’t dig much deeper to find out why.

They should. We would have better governments if we used some second order thinking once in a while.

The takeaway

The citizens are going to lose and lose big this time.

People need to be more informed of the probable outcomes from government actions. Inflation is just one of them.

If we want to help ourselves, we need to learn more, pay more attention, and demand standards from government that match our own. The principle of these is take responsibility.

Wow, that was depressing. Sorry.


I help people have more retirement income and larger, more liquid estates.

Call in Canada 705-927-4770, or email don@moneyfyi.com

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.

%d bloggers like this: