Monetary inflation has a very simple explanation: As the amount of money in a system increases, and the number of purchasable goods in the system remains fixed, or increases at a lower rate, the relative prices of goods increase to match their expected value.

While that explanation sounds dry, it can be illustrated a bit more viscerally. We'll look at housing prices; during the housing 'boom' of the early 2000s. As loans got easier to get, and more people entered the market, demand for houses (and attempts at speculation on houses – buying a house, improving it, and reselling it) drove house prices up at an astonishing rate. In effect, because of the low interest rates available for loans, and then programs to give loans to anything that could sign its name and prove it had a social security number, housing prices inflated. This is an example of an investment bubble….but it demonstrates a truism: The value of a thing is what its purchaser will pay for it.

When monetary standards (interest rates and lending practices) relax, this is nearly the same as running the printing presses; the total amount of money in the economy increases, and prices rise to meet the new equilibrium. This price rise is called inflation.

Inflation in the modern sense stems from relaxing credit standards. In a classical sense, inflation usually stemmed from the problems of fiat money (dating back to the first experiments with this in China) or devaluation of currency on a harder standard, such as gold or silver.

Fiat money, in theory, gives the state a lot of flexibility over economic policy. It allows the government to expand the money supply as needed, and done gradually, this gives the illusion that it can reduce the time spent in a recession. When you combine fiat money with a representative government, there is a nearly uncounterable set of incentives to inflate the currency. Politicians want to keep their jobs, constituents lose their jobs in a recession, so the spigot on the money supply is opened up, whether directly through stimulus checks from the government, or indirectly through the Federal Reserve adjusting the prime lending rate, which ripples through the rest of the banking system. In effect, you can subtract the rate of inflation from the rate of interest or returns earned on an investment, and find the net rate of return. This can result in a negative rate of return, even if numbers at the bottom of the balance sheet keep going up.

Every historical instance of a fiat currency has run into significant inflationary cycles, usually within 60 to 80 years of its institution, and often times sooner. The temptation to 'just this once' inflate the currency to get over a crisis turns into 'well, it didn't have a bad effect last time, so we'll do it again…' and the process repeats. Incrementally, and beyond the time horizons of elected offices, most fiat currencies undertake an accelerating inflationary spiral.

However, currency inflation isn't always tied to monetary policy. Even when currency is backed by a hard standard, (where each note can be redeemed for a given weight of specie), there can be inflation. Indeed, the worst economic cycle in US history – worse than the Great Depression – came about indirectly because of an inflation-deflation whiplash caused by the discovery of significant amounts of silver in the mountains of Nevada. This lead to a great specie speculation bubble, which resulted in a near doubling of prices across the board (more silver was available for currency, more currency was issued). Unlike modern fiscal policy, where there was no centralized bank of the United States, there was a severe currency adjustment (effectively devaluing the money, or deflation). This rapid inflation-deflation whiplash happened at a particularly bad time of the year. The largest aggregate users of credit in the1880s were farms; they'd take out loans in the spring to be paid back with proceeds earned after the harvest. When the devaluation of currency happened in September, the entire edifice ground to a halt, as the price they could get for the farm sales couldn't even cover the interest on their debts, let alone the principal.

Inflation-deflation cycles have been common throughout US history, and can be seen as markets adjusting due to demand and price signals. However, there's another cause of inflation in modern economies: Government debt. When there's an extant government debt, inflating the currency means that you can pay off the debt with money that's worth less. When government debt levels hit a certain portion of the gross domestic product, the end result is inflation that grows at more than 100% per year; in some cases, it can grow to thousands of percent per year, and at this point, you get hyperinflation; a point where the largest unit of pre-inflation currency can't buy a loaf of bread.

Also see my article; The Truth About The Unemployment Rate

• Hyperinflation

• Economic Recessions

• The New Depression

© 2009 Robert Lee, all rights reserved