"This currency, as we manage it, is a wonderful machine. It performs its office when we issue it; it pays and clothes troops, and provides victuals and ammunition; and when we are obliged to issue a quantity excessive, it pays itself off by depreciation."
~ Ben Franklin, April 1779

These words, spoken by one of America’s founding fathers acknowledges, one of the privileges of government: access to the monetary printing press. In June 22, 1775, the Continental Congress issued two million dollars on bills of credit. As the Continental Congress began making preparations for war with England, it needed a source of revenue to help pay for the coming conflict. Since taxation was a root of the conflict, raising taxes wasn’t even considered. Instead, Congress resolved to pay for the war through the issuance of paper money. In essence Congress did what governments have done throughout all of history, which was to debase the currency through the issuance of excess quantities of money. The first Great American Inflation was about to begin.

Since taxes were unpopular with the people, the States never raised them. This left the government with no choice but to issue ever-increasing amounts of money. The result is illustrated in the table above.[1] From its origination in June of 1775, the aggregate amount of bills in circulation rose to $241,000,000.

The immediate result was that the paper currency began to depreciate in value. “In January, 1781, Captain Allan McLane paid $600 for a pair of boots and $10 for a skein of thread.”[2] From its original printing in June 1775, the Continental dollar had lost over 66% of its value by the following year. To combat a depreciating currency, the States made the new paper currency legal tender for all debts and purchases. They enforced the new currency with price controls and instituted fines for refusal of acceptance as legal tender. As the government printed ever-larger amounts of money, they enacted laws making it a crime to refuse payment, to charge lower prices for specie, and to demand a premium for payment in paper. However, this did not stop inflation. Individuals took evasive action.

Source: Prof. Robert C. Sahr, Political Science Dept., Oregon State Univ., used with permission

Farmers refused to grow crops, leaving the government and its army to impressments (seizing property for public service or use). Those impressed altered their behavior by hiding crops, livestock, horses, and machinery; anything that could avoid their being confiscated through the forced sale by government officials.[3]

By the beginning of 1780 the government realized the jig was up. By then it had issued $241 million in Continental dollars. The States had issued $209 million of their own notes. Additional millions had been issued through counterfeiting by the British and private individuals. In the end the government was forced to call on the States to retire the debt by issuing taxes payable in paper or specie; specie being defined as one silver dollar, which was equal to $40 in taxes. The government had learned that there was a limit to the amount of debasement an economy or a populace could withstand. Despite the government's best efforts to force its will upon the people, the people found an end means around these controls; from barter and hoarding of goods to the use of alternative money.

Government officials, including Mr. Franklin, continued to defend the practice. For the remainder of the war Congress continued to issue paper money, albeit at a slower pace. In Franklin’s words as noted in my introduction, the issuance of paper money was a ”wonderful machine" as it allowed the government to pay its bills without enacting taxes. From the birth of this nation to the present, the government would from time-to-time resort to debasement of the currency in time of war or in time of economic duress. We find it always ends with the same consequences: debasement of the currency and concomitant inflation. Despite the best efforts of government alchemists, the result is always the same in the end – inflation.

Source: Prof. Robert C. Sahr, Political Science Dept., Oregon State Univ., used with permission

Fast forward 230 years later and we find the same mistakes made by government. We now have another Ben in charge of the nation’s money. Like his predecessor, Mr. Franklin, our current Ben has a similar philosophy. The two Bens could have exchanged places with each other and given the same speech.

“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But there U.S. government has a technology, called a printing press ( or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of dollars in circulation, or even credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is the equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” ~ Ben S. Bernanke [4]

Our present “Ben” was acknowledging an irrefutable law of money. This law is better known as the “Quantity Theory of Money.” Under the “Quantity Theory of Money” and under a system of fiat money as we have today, the supply of money can be increased to any amount the government desires. The historical tendency of government is to accelerate the quantity of money in circulation as a means of covering government’s voracious appetite for expenditures. What isn’t feasible under a system of taxation is made up through money creation. The only limit to the quantity of money created is the destruction of its value. If a government creates too much money, it has the risk that debasement runs ahead of the government printing presses. At that point money ceases to be accepted as a means of payment. The result is it loses its character as money. In the end the government's counterfeiting scheme is exposed and stopped.

In his book “What has Government Done to Our Money,” Murray N. Rothbard describes the ultimate outcome of such practices: "With fiat money established and gold outlawed, the way is clear for full-scale, government-run inflation. Only one very broad check remains: the ultimate threat of hyper-inflation, the crack-up of the currency. Hyper-inflation occurs when the public realizes that the government is bent on inflation, and decides to evade the inflationary tax on its resources by spending money as fast as possible while it still retains some value. Until hyper-inflation sets in, however, government can now manage the currency and the inflation undisturbed.”[5]

One of the ways government manages inflation is through ignorance of money. By obfuscation the government creates the impression that inflation is caused by elements other than its own money-printing. I covered this issue in my “Great Inflation” piece written in the fall of 2004. Perhaps a part of this bears repeating below.

WHAT CAUSES INFLATION?

Ask any person today what causes inflation and they will tell you that it is rising prices. Like many issues on money, the inflation issue is clouded and confused. That is because the inflationists want it that way. By focusing attention on rising prices, it takes the attention away from the cause, which is excess money creation. Instead, all of the attention is focused on the symptoms of the disease rather than the root of it.

There are only three ways that prices can rise. The most important influences are as follows:

1. The supply of money and credit

2. Supply of goods and services

3. Demand for goods and services

Prices can increase by:

1. Increasing the supply of money

2. A decrease in the supply of goods and services

3. An increase in demand, i.e. population increase

Conversely, prices can decrease by the same three measures when:

1. The supply of money declines

2. The supply of goods and services increases

3. Demand decreases

These are the only three ways that prices can increase or decline.

There is very little understanding of where inflation comes from or where it originates. Most individuals define inflation as rising prices. They speak about symptoms rather than cause. If inflation is simply rising prices, then what causes it? You’ll find that inflation is attributed to many sources—none of which are accurate. The common misperceptions by policymakers and the public is that inflation has three principal causes:

1. Cost-push inflation as a result of arbitrary demands of labor unions.

2. Profit-push inflation resulting from the greed of businesses raising prices.

3. Crisis-driven inflation resulting from acts of God or weather.

The general belief that inflation is the result of something other than its true cause makes it hard to understand and resolve. Most people believe that inflation is conspiratorial such as OPEC raising crude oil prices, businessmen wanting to make higher profits, or unions looking to enhance worker benefits and pay. Somehow inflation has become an evil caused by greedy individuals and businesses. To most people inflation has become a causeless phenomenon inexplicable and born of ill will.

LET'S GET THIS STRAIGHT

Definition

There is irrefutable evidence that government is the source of all inflation. An undue increase in the quantity of money is what stands behind a rise in prices. The source of all money or credit is government. Thinking of inflation only in terms of rising prices is similar to looking at the symptoms of a disease rather than the disease itself. A more exact definition of inflation would be an increase in the quantity of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level, an increase in the quantity of money caused by government.

You will notice that this definition doesn’t say anything about cost-push, profit-push, or crisis-push inflation. It simply states that the supply of money expands leading to higher prices. It is the expansion of money and not rising prices that leads to inflation. This also points to the real cause behind inflation as government intervention in the economy and financial system by expanding the supply of money and credit in the system.

Formula

When the government increases the supply of money and credit in the economy, it increases demand for goods leading to higher prices. Higher demand or lower supply is the only conceivable cause of higher prices. It can be demonstrated by the formula below: [Price Level = Demand/Supply]

 P = Dc
       Sc

To expand and elaborate on this formula, we must add a time factor, which is how long and how fast the holders of money decide to make it available. Lord John Maynard Keynes referred to this as “liquidity preference,” or how much and how long the holders of money liked to keep it on hand. The reverse of this is called the velocity of money, which measures the volume of purchases relative to the supply of money. Money velocity is the hardest to understand because it is dictated by psychological factors. The volume of spending within an economic system is not only determined by the supply of money, but also by the demand for money. The greater the demand for money, the greater is the preference to hold it. (Keynes’ liquidity preference) The smaller demand there is for money, the less preference there is by holders of money to want to hold or store it. Simply put, the greater the demand for money, the lower the velocity and the smaller the demand to hold money, the greater the velocity.

When individuals decide not to hold money and instead have a preference to spend it, the velocity of money increases. Likewise, when there are desires to hold money instead of spend it, the velocity of money decreases. Therefore, to our quantity theory of money, we must add velocity to the equation. The new formula for price levels can then be stated as follows:

The new equation shows that the general level of prices moves in direct proportion to the quantity of money and its velocity. Price levels move in inverse proportion to the aggregate supply of real values. If money velocity is held constant, then price levels will depend on the quantity of money. It is only when people begin to distrust money and feel that the security of their money is being threatened that money velocity increases. When the value of money is insecure, the demand for it falls. There is less of a desire to hold it because its value is depreciating. People dispose of their money and find a replacement for it in tangible goods that are real. The desire to own commodities or real goods increases because these goods represent a better source for meeting future cash needs.

During the latter stages of inflation, money velocity increases because people no longer have faith in their currency. As shown in the chart below, the depreciation of the Reichmark increased as the supply of money expanded as did money velocity. Money velocity is a direct reflection of the degree of confidence that people have in their currency. A sharp increase in velocity normally takes places during the final stages of an inflationary crisis.

INFLATION IS HERE IN 2005

This brings us back to where we are today. Once again inflation is on the rise. Through September the PPI was up 6.7% year-over-year, while the CPI was up by 4.7% over the same period. Even worse for Americans, who now import more of what they consume, import prices are up 9.9% over the last 12 months.

Given the fact that the PPI & CPI numbers are inherently understated through statistical manipulation, it is hard to ignore the fact that inflation is on the rise. However, the chorus on its rise is being blamed on something other than its cause. The political and financial media are focusing on the symptoms rather than the root of inflation; excess money and credit created by government and its central bank, the Federal Reserve. Instead of excess money and credit, the blame for today's inflation is placed on greedy oil companies and acts of nature (Katrina, Rita & Wilma). We have official acknowledgement of inflation, but the blame as been shifted elsewhere.

Today the true rate of inflation is running well over 7% as shown in the chart above by John Williams. Williams maintains the CPI index as it was originally constructed before the government began to tinker with the index. The pre-Clinton CPI portrays a different picture than the numbers popularly bantered around by the press. It more closely relates to what most Americans experience daily in their lives.

As the price of oil rises and inflation surfaces throughout the economy with rising medical premiums, rising gasoline costs, utility and college tuition increases, there are cries for government to do something about it. We have now reached the point where the public realizes that inflation is on the rise. We have passed the point where it is considered temporary. Inflation psychology is taking hold and that is what worries the Fed. If that psychology gets out of hand, confidence in the currency diminishes and along with it, the government’s ability to contain inflation without taking drastic action that could imperil the economy and the financial markets.

DO SOMETHING ABOUT IT!

In typical and predictable fashion there are cries for government to do something about it. So the fox is being put in charge of the henhouse. Proposals are surfacing everywhere. Two of the suggestions are to apply a windfall profits tax on the greedy oil companies and to impose price controls on the products they sell. U.S. Senator Byron Dorgan (D-ND) plans to introduce a bill that would impose higher taxes on oil companies once prices rise above $40 a barrel. Hillary Clinton (D-NY) has recently called for a $20 billion tax on oil companies to help fund alternatives and help boost funding for the Low Income Home Energy Assistance Program (LIHEAP). Out of ignorance of what causes inflation or what causes higher oil prices, the public is calling for a solution. Public opinion polls show that 4 in 5 Americans want a windfall profits tax on “Big Oil.” 

Is Fair Share Fair?
On the day this was written ExxonMobil, ConocoPhillips and Microsoft all reported third quarter profits. Exxon Mobil reported sales of $100 billion and profits of $9.9 billion. ConocoPhillips reported sales of $49.7 billion and profits of $3.8 billion. Microsoft reported that sales rose to $9.7 billion and profits rose to $3.14 billion. ExxonMobil earned a 9.9% return on sales; ConocoPhillips earned a net return on sales of 7.65%. Microsoft’s profits reflect a return of 32.2% on sales.

The rise in ExxonMobil’s and ConocoPhillips' profits promptly called for a windfall profits tax to be imposed on the oil companies. Microsoft’s profits of 32.2% on sales called for no similar action nor were there calls for windfall profits taxes on homebuilders, banks, and other technology companies who all reported higher profits on sales. The oil companies have become the government’s new whipping boy for government-created inflation. The object of course is distraction and shifting the blame.

The Blame-Shifters
On hearing of ExxonMobil’s profits, Senate majority leader Bill Frist said oil company executives will be called to testify at a hearing on the reasons of high energy prices. House majority leader Dennis Hastert pleaded with oil companies to find new sources of oil, natural gas, and build new refineries. On the same day a partisan fight in the Senate doomed a new federal incentive to increase the nation’s oil refinery capacity for at least another year. According to The Wall Street Journal, the Senate Environment and Public Works Committee deadlocked 9-9 over a Republican proposal that would streamline federal and state permit procedures for companies that want to build refineries or expand plants. Eight Democrats and one Republican voted to block the measure. A Democratic strategist said the Democrats see political opportunities in recent announcements of high oil company profits and plan on using it as an election issue in next year's congressional races.

As we see inflation's inexorable rise, there are further cries by an uninformed public for government to fix it. The exact programs that are called for today—a windfall profits tax, price controls, and various taxes—were tried before with disastrous results. They led to gas lines, shortages, higher energy prices and greater dependence on foreign oil. “The United States has tried this before, between 1980 and 1987, and the results were hugely counterproductive, according to a 1990 Congressional Research Service report. The WPT reduced domestic oil production between 3 and 6 percent, and increased oil imports from 8 and 16 percent,“ says the report. “This made the U.S. more dependent upon imported oil."[6]

INFLATION / DEFLATION

It should be crystal clear by now. Higher prices at the pump and at the supermarket are not inflation. They are simply symptoms and not the cause. The rise in oil prices because of tight supply and greater demand has nothing to do with inflation. The same with rising food prices, which are dependent on global demand, weather, and the success of the year’s harvest. Inflation has and always will be a monetary event brought on by government and its central banks. It is caused by an expansion in the quantity of money. Deflation is caused by a contraction of the supply of money. As shown in the chart below, inflation has been almost non-stop since the establishment of the Federal Reserve.

Source: Prof. Robert C. Sahr, Political Science Dept., Oregon State Univ., used with permission

We have only had a few brief moments of deflation. They occurred when the U.S. was on the classical gold standard or the gold exchange standard when gold acted as a restraining force on government. The last great deflation occurred during the Great Depression when the U.S. government still used gold to back its currency.

The next graph shows that over the last 35 years, especially since abandoning the Bretton Woods system in August 1971, the money supply has increased from a low of $613.3 billion in February of 1970 to $9,976.7 billion as of September 30, 2005, an increase of more than 1,500 percent.

During that same period, the price of housing has gone up ten-fold or 1,000 percent.

For those who like to measure inflation and deflation inaccurately in terms of rising or falling prices, the last time the CPI was negative occurred in 1955 when Eisenhower was President. Since that time we have had inflation every year and every decade.