Inflation, deflation, fiat money, currencies…

One more crack at the inflation/deflation dynamic.

In order to provide for yourself and in order to provide for society at large, we must ensure that the economy as a whole expands at a certain rate. This rate can be calculated taking into account a number of factors such as the national birth rate, the rate of immigration or the ambitions of a country to name but a few.

Money is the blood that animates the economy. Without some form of money we’d have to make do with barter. There is nothing wrong with barter other than the fact that it is a cumbersome system and only allows for few transactions to take place between a restricted number of actors at any one time.

Money is only a vehicle that allows exchange to happen. Money is not wealth. Money allows you to acquire wealth but it is not wealth. Money is a vehicle.

Therefore, the amount of money in circulation must grow in relation to economic expansion. The larger the economy, the more money should be placed in circulation… and vice versa.

Whether of a democratic or tyrannical persuasion, governments must choose a monetary system. Short of going back to barter, governments must make use of some type of money. There is no alternative.

Money can be based on some value related to the national economy or not. It if is, it for example could be a metal based monetary system. If it is not, it is a fiat monetary system.

In a metal based monetary system, the quantity of money in circulation can only be expanded by locating, extracting, conveying, refining and distributing more metal. Thus, in order to expand the quantity of money in circulation in a metal based monetary system, a government must employ people and machinery and must allow for a certain time for the process to be carried out.

In a fiat monetary system, the quantity of money in circulation can be expanded at will. There are no material or temporal limits to increasing the money supply in a fiat monetary system.

Money is like anything else in life. When there is a lot of something useful, the value is cheap. When something useful is scarce, it is more valuable. Think of tomatoes. If suddenly the entire tomato crop of the world should be wiped out by some virus, suddenly the value of tomatoes would skyrocket. But since tomatoes are plentiful, their value is fairly low and the greater a yearly crop, the lower the value of each single tomato would be.

Money is the same.

If the economy as measured by GDP is expanding at 4% yearly and money supply (the amount of money created) is expanding at 15%, money loses value. This is what inflation does. When government creates and injects into an economy a quantity of money that is greater than the rate of expansion of said economy, the currency loses value; i.e. you cheapen the currency; i.e. you need more currency to purchase an item like a pen or a hamburger. In other words, the price of the pen or of the hamburger increases. Thus, rising prices is the manifestation of inflation.

Society has been conditioned to think that rising prices are the cause of inflation. Few people will stop to think what, then, makes prices rise?

The truth is of course, that it is inflationary monetary policies that cause rising prices.

(N.B – increases in prices can also be brought about by scarcity. This is particularly the case for commodities. Scarcity can come about in absolute terms as is the case for gold whereby the quantity of this ore in the earth’s mantle is less compared to other ores. Or, scarcity can come about in relative terms whereby demand is greater than production capacity as may be the case for grains for example where there is a time lag between production and harvest. But in the West by and large, rising prices are the result of inflationary monetary policies that go back decades. Since today we are all on a US$ based fiat monetary standard, you can see the effects of inflation in the next two charts.

This is the % rate of expansion of US GDP since 1929. You will notice that GDP since the late 40s has expanded at a leisurely pace of (to be charitable) 5% on average year on year.[1][id]=GDPCA&s[1][transformation]=pch

FRED Graph

This is the rate of expansion of the money base. MZM is not a perfect measure of the monetary base but it nonetheless captures the essence of my argument. Here you have monetary expansion that is on average twice as high as GDP expansion year on year.[1][id]=MZMSL&s[1][transformation]=pc1

FRED Graph
From the official statistics above, it is clear that Western society has been subjected to a grossly inflationary environment for a good many decades. Hence the reason for constantly rising prices. )

So, with regards to the economy, one of the presumably implicit fiduciary duties of government is (or should be) to protect the value of money by ensuring a degree of money expansion or contraction that does not grossly exceed the expansion/contraction of the economy.

You read that right. In a sound economy, the money supply should expand and contract with the economy.

In an environment where government induces the expansion of money to greatly exceed the expansion of the economy, you have inflation. When a government induces inflation aggressively, pervasively, consistently and relentlessly in a monetary system for many decades, you have debasement of the currency.


Both metal or fiat monetary systems can be subverted of course. There are myriad examples of currency debasement throughout history, most perpetrated on metal based money. But as is clear from the definition above, fiat money allows for debasement that is orders of magnitude greater than metal based money.

The only thing that stands in the way of monetary debasement is the fiduciary duty of government.

One of the greatest incongruities of Western “democratic” society, is that the choice of monetary system is not part of the democratic process. The monetary system adopted by our respective governments is imposed unilaterally and arbitrarily. More dangerous still, is the fact that not only is our monetary system imposed by presumably informed politicians, but the authority to create money is also retained by government or given to an independent entity that has close ties to government like the Federal Reserve.

So, Western democratic societies in fact, are only partly democratic. Specifically, when it comes to the blood that animates the economy and that is supposed to provide for us all, government has decreed that society should have no say.

In defense of government, it must be said that society has never really cared much about money. Certainly, everyone wants money and most devote their lives to accumulating as much of it as they can by various means. But few people, if anyone indeed, wonders what money is, where it comes from and what gives money the value that is assigned to it.

Indeed! What makes the $10 bill in your wallet worth ten dollars? What constitutes ten dollars worth? How is the value of a currency related to one’s wealth? Is the value of a currency related to one’s wealth?

All valid questions of course but here I am concerned with explaining what inflation is, how it works and what the ramifications of inflationary monetary policies are.

We have now objectively established that inflation is a monetary phenomenon induced willingly and deliberately by government.

The question is: why?

The short answer is: because that is the nature of politicians and, by extension, that is the nature of government.

The inference of the above statement is that a “democratic” society is inherently and by necessity inflationary. There is no alternative. That is because the very nature of politics is inflationary. Politicians must make promises to the electorate and then at least partly deliver on promises. One cannot hope to make a political career without promising and delivering some sort of improvement regardless of how things may be going. If things are going well, a politician must promise better times still. If things are going badly, a politician must promise better times. Therefore, the political process is inflationary because a politician must spend money. In a democracy, given the choice of two politicians one of whom advocates spending cuts whilst the other advocates improvement without the need to cut spending, the latter will always prevail over the former. Thus, whichever way you slice it, democracy is inflationary by necessity.

The keenest observers amongst you will deduce from the above that if a democratic society is inherently inflationary, a non democratic society is better suited to escape the devastation of the inflationary cycle. Although this is a discussion for another time, I can tell you that it could indeed be so technically; but it most always has never been the case.

Now, since we’ve established that the political process is inherently inflationary, the question is: if you were a politician, what monetary system would you rather operate under?

A metallic monetary system would necessarily slow down the monetary creation process. Thus infrastructure, military, social or scientific projects could only be financed over a longer period of time.

In a fiat monetary system, any politician can dream up a scientific or military project, wake up and finance it with money that can be created instantly.

The rationale of a fiat monetary system is that we create money today to finance projects and campaigns that will bring us profits in the future.

That is the theory of course.

Here’s the problem.

Inflation is a dynamic that is exponential in nature and that has a mathematical limit.

Inflation is exponential because when you create money faster than the rate of expansion of the economy, you are inducing a rise in prices that is not due to demand but to the devaluation of the currency. At the beginning of the inflationary cycle, the effect of inflation on prices is minimal. But as the money creation process expands consistently faster than the economy, inflation will make up an ever larger proportion of the rise in prices. Inflation grows, matures, declines and dies; this is a logic enshrined in all dynamics and inflation is not different. And this is the crux of the problem.

By making the deliberate choice to adopt a fiat monetary system, government implicitly accepts and imposes on society the inflationary cycle. Imposing a fiat monetary system on an ostensibly democratic society guarantees inflation.

It follows that the survival of politics and government are predicated on the perpetual expansion of inflation. It couldn’t be otherwise. There is no alternative.

But if inflation has a mathematical limit, it follows that once past the peak of the “beneficial” effects of inflation, government has a vested interest not only in maintaining the inflationary trajectory but also in pushing it faster exponentially.

In this essay and this one , I explain some ways that inflation can be induced in the system and why. Essentially, as the inflationary dynamic matures and declines, inducing inflation becomes increasingly difficult, onerous and … illegal…but vital.

Remember that government cannot exist in the absence of inflation. Thus towards the end of the inflationary cycle, government has a vested interest in tolerating and/or disregarding certain practices that are illegal particularly in the financial sphere.

As 2009 progresses, it is clear that in the USA and in the West in general, governments have not only tolerated but also sponsored illegal activities in the recent past. Most notably in the USA, the government has contravened the letter of the law by bailing out the bond holders of the largest banks whilst negating the right to due process to the bond holders of the car manufacturers. Also, government has used public funds to buy into Fanni Mae and Freddy Mac when two clearly failing enterprises that have committed accounting fraud for decades. The laundry list is indeed extensive and you can find examples yourselves.

What matters here is that I believe we’ve finally entered the devastation phase of the inflationary dynamic and by carrying on as Western government have been, the only way out, eventually, is going to be a world war.

Once the inflationary dynamic can no longer be expanded, government is bankrupt.

In this essay and other related to it, I lay out why I think that at this point, a world war is all but inevitable. Here is the relevant excerpt:

Where we are today.

In point 3 on page 8 of its December 2007 report, the Bank of International Settlements estimates the global value of derivatives at US$500Trillions. That is FIVE HUNDRED TRILLIONS

To put things into perspective, global GDP hovers around US$40Trillions. Many economists and finance professionals have said and will say that the 500T is only a notional value. However, considering that world GDP is a fraction of this notional value, toying with 500Trillions is not desirable under any circumstances. Anyway, since then, this debt mountain has proved that “notional” can become rather “real” very quickly. But what is more interesting is that as the logical conclusion of the inflationary cycle is reached, turnover in these credit instruments goes into overdrive.

Now; considering that in 80 years of priming inflation all we have to show for is exponential growth in inflation but GDP growth that potters about in the low single digits (greatly goosed by hedonic adjustments a sober explanation of which is here), you would think that someone somewhere would suggest that maybe, just maybe, more of the same might be counterproductive at this point???

Pervasive, persistent and aggressive inflation pumping over the past 80 years (we must calculate 80 years because as we have chosen to adopt the US Dollar as reserve currency, today we have to bear the cost of US monetary policy from the inception of the modern Dollar in 1913) has come full circle. Inflation has a mathematical limit. Once the limit is reached you must find new people to contribute to the scheme or you must find a new asset class to inflate or your must devalue the currency usually by introducing a new currency.

If none of those three things can be achieved, governments become insolvent.

An insolvent government can neither provide the services citizens have come to expect of the state nor, indeed, can it make good on its external debt.

However, a Western government cannot declare bankruptcy.

… if a Western government cannot declare bankruptcy and yet it can neither provide for its citizen nor make good on its external debt, then what… ????

Thus, unless someone can re-start the velocity of money, somehow, in some asset class, we are hurtling towards a world war.

Money velocity below one along with money and credit pumping in the face of a global debt burden estimated by the Bank of International Settlements to be 500 Trillion Dollars to be serviced by a global economy that was at one point worth about 40 Trillion Dollars spells war folks.

Keep an eye on the velocity of money.

Got bullion?


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4 Responses to “Inflation, deflation, fiat money, currencies…”

  1. Bank of International Settlements June 09 report « Guido’s temple of the absurd Says:

    […] […]

  2. Guido’s temple of the absurd Says:

    […] guidoamm As shown here, here, here and in many other posts on my blog, in a fiat monetary system, inflation is the reason […]

  3. If pictures are worth a thousand words, let me try this… « Guido’s temple of the absurd Says:

    […] writ large. Looks like I am wrong. For more on the inflationary dynamic, you can read this post and many others on my blog. Possibly related posts: (automatically generated)Inflation, […]

  4. Exeis » Blog Archive » Inflation, deflation, fiat money, currencies… - A RSS agreggator in financial bloggging experiment. Says:

    […] Link to the original site and story. […]

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