Thursday, July 17, 2008

No, Really, Inflation Hurts You but Helps Them

I know I keep harping on inflation.  Many people do.  Some may think I'm just trying to sell gold.  In reality, I think that most people who are 'gold bugs' are just trying to convince others of the importance of hedging their savings.  Much of the arguments presented here are counter-intuitive but make sense.  This is a sort of compendium of the reasons I don't like inflationary practices.

First, we'll consider the effects of inflation on banking.  Initially, inflationary policies can seem great, or people would not tolerate them.  True inflationary policies start with something called 'fractional reserve banking'.  This is a system where banks build capital out of deposits and then loan out a part of the capital on the theory that not everyone will want their money back at once.  Initially, nobody thinks this is inflationary because, technically, there's the same amount of money out there; it's just all being used instead of some being saved and some being used.

The problem is that the money that is deposited in the bank in a liquid account, an account that is expected to have funds available at any time, are funds that someone counts as liquid money.  That means they compare value based on what they have in liquid funds for their daily transactions.  At the same time, someone else borrows that money and spends it, meaning the money is at once available to be spent and spent.  This does not inherently increase price, as the money is only spent once so the price is not directly bid up.  However, the person who has the money may have bought the item at a lower price were the loan not available and the higher price not sustainable.  In other words, it does increase the amount of money available to spend, which has an upward pressure on prices, particularly capital goods prices.

So, the first evil of inflation in money is obviously inflation in prices.  This causes 'capital misallocation', causing sound companies to have trouble competing with those who do not have any problem carrying a high debt load.  Since the work must be done by a laborer, that laborer is not doing other work.  Misallocation has workers chasing rainbows, making things people may or may not want based on future income projections and what monetarists think are appropriate loans.  Thus do we have an average of, what, eighteen months in business for a new gas station.  It also means established mom and pop gas stations can't compete with slick new stations built on credit that have bought their stock on credit.

So, we come to another evil of inflation, that of driving the small business man to the margins.  Anyone with a dream and a prospectus can get a small business loan to open a new business.  What this means is that a family business, which may or may not be able to acquire funding, must compete with a business that is just starting with a good prospectus.  The business that is starting may even use the mom and pop business' numbers to justify their existence.

Now, some say that the lower prices and better service are the reason the new store wins, but we're reaching another evil of inflation.  Inflation drives capital investment.  A loan, once executed, in an inflationary enviroment will reduce in liability for the life of the loan, meaning that as time goes on, the cost to the business from having taken out the loan is reduced.  So, the business now has to consider buying a machine that, say, makes ten tortillas an hour or paying a man that makes ten tortillas an hour.  The machine's cost is now fixed, meaning its cost will not go up over time, and, in a relative sense, will actually go down as it is amortized and the loan is reduced through the magic of money being worth less.  However, in the same environment, the employee will require constant increases in pay, both for senority and for inflation.

Really, there was a time when a given job was paid a given amount for the duration of a man's life.  Wage increases came from climbing the ladder, not senority.  However, these days, any raise less than the rate of inflation is a de facto pay cut, so employees have come to expect a 3% raise per annum, which has been below the actual rate for some time, but that's another argument.

Now, the employer will seek every way he can to reduce his headcount so he can reduce the constant increasing costs.  He also can purchase the device on credit, saving his capital for other uses.

So, the increase in inflation causes a reduction in employment particularly among unskilled and semi-skilled labor.

Which brings us to another evil: the rich get richer.  We already discussed how the poor get poorer, but now we'll deal with how the rich get richer.  If I were an investment banker, I would be able to make interesting bets using 'leverage'.  For instance, during the heyday of the 'Yen carry trade', investment bankers borrowed Yen at around 1% from the Japanese interbank system.  They then bought US T bills at around 4%.  Say they put down a million dollars to borrow nine million, which is conservative.  Their ten million dollars will add on three hundred thousand more than the interest cost on the original loan.  This means their original million dollar stake is turning 30% per year.   Get this: they can double down on the gains after a little over three years and start making six hundred thousand a year off of two million.  Essentially, at 30% per year, you double your money every three years or so, meaning you are rapidly unable to secure loans to match your available funds, which means you have to park them somewhere, which severely distorts other investments by driving down yields.

So, the rich get richer by getting inflationary funds first.  This is the point to remember, that the banks and bankers always get the money first, before the rest of us see it lose purchase price, so they get to buy with new dollars amounts of stuff that we would not be able to buy with the same money because by the time we get it, the value has been reduced.

So we come to the middle class.  The lower class depends on social security for their retirement, among other things.  They do not necessarily make investments.  The middle class makes investments.  Well, with the bankers having money to drive investment, and, indeed, so much money that they can afford to drive markets if they want to, and also they can afford to lose.  This means they will chase slimmer margins and wildcat on riskier investments.  The middle class cannot afford this, so their money has to chase more stable investments, which often end up losing money in the long run because there is simply too much money to invest.

So, over the long run, the middle class loses purchasing power in its savings, although its debt load is reduced.  The lower class loses income and has a hard time obtaining assets.  Those with access to the money gain more money.

So, what is to be done?  Well, we could just wait.  The kind of people who are ok with making money without producing more value tend to also get greedy.  Sooner or later, they push the whole thing too far and the value of money begins to plummet in an inflationary spiral.  Alternatively, their entire house of cards evaporates and the whole thing spirals into deflation, causing the rich to lose their lunch either way.  The middle class, those with skills, often do well in either case because someone must do the things that keep the cogs moving in this world.  However, the lower class with no mobility and few options begin to riot.  Thus begins a period of civil unrest that seems to source from intractable social issues but is really driven by the most fundamental need of man, which is to be secure about his house and possessions, and to have some of the things he thinks he needs for the good life.

We are seeing this progress in France right now.  The United States is a long way behind, but the trajectory is the same.  Both countries have been pursuing ever more regulated and redistributionist economies, to the point where France has essentially a one month guaranteed vacation and no way of firing a new hire.  This means, of course, that jobs are very scarce.  So, there are a lot of young men with nothing better to do with their lives than pursue Islamic superiority.  Were those young men employed, they'd have less energy to devote to burning half the city.

A similar situation obtains in the United States, where drugs are a result of urban decay due to majestic mismanagement of urban funds, the availability of wellfare, and the prohibition of drugs.  Each leg is a part of what allows the situation to continue.  Cities raise taxes to help pay for the corruption, graft, and mismanagement common to cities these days, which drives both businessmen and wealthy out of cities.  Thus do the lower class move in, property values plummet, and cities are forced to raise taxes even higher to meet the new demand on law enforcement and so on caused by the collapse of the culture.  At the same time, people cannot find work, so go on wellfare, which provides an incentive in many cases to raise a larger family and avoid marriage, as both result in effectively lower payouts.  This destroys the family unit, causing an increase in crime, as the lack of an effective father figure is the number one determining factor in the potential for criminal activity in young males.  Now, with nothing to do and no effective discipline, the young man turns to the fabulous world of drugs where he can make it big, since he has no other real opportunities.  Since the city has mismanaged itself so badly, and is not paying its employees, particularly police, enough, the criminal element can pay off the police force in many cases, and soon it becomes very nearly impossible to stop the decline of the city.

Remember, though, that it is built on three things, mismanagement, wellfare and drug prohibition.  Remove any of those three things and the problem will largely be reduced.  Remove two of them and the problem pretty much goes away.  If you remove the prohibition on drugs and the wellfare, the families will be forced to move to find income, as drug money dries up due to large pharmaceuticals easily out competing drug cartels and the families no longer having wellfare.  This means much more vacant city area, which is potentially a good thing, as that will allow businesses to move back in at a much lower stated value, so lower tax.  Also, as their tax base dries up, the city will be forced to scale back on everything, including corruption, which will cause some of the more corrupt officials to seek graft elsewhere.

Should the city become better managed, as New York did, it can more effectively deter crime.  This did reduce drug trafficking.  However, were drugs legal, and deterrence more effective, crime would largely go away.  Ditto better management and no wellfare, as workers would once again have to move out to pursue income.

All of this has a point.  Redistributionist and deficit spending policies are essentially inflationary.  If someone takes a dollar from me and gives it to someone else under the guise of social wellfare, they have taken production from me and given it to someone who did not produce.  Now I am forced to compete with that person for goods that have been produced.  However, the actual amount of goods produced has not changed; the percentage that those who have produced goods get of the amount produced has gone down, which is an increase in price from their perspective.  This is not monetary inflation; this is actually reduction in production leading to price inflation.  Were that dollar not redistributed, it is likely that the other person would be force to produce something for his money, leading to greater production, however marginal, and a reduction in prices as a result.  The funny thing is that it is actually additive.  Every extra thing he produces lowers effective prices for everyone else as well as himself, so he gets more of the pie by producing more.  Every thing he gets for free reduces the pie for everyone so his portion of the reduced pie is worth less.

That is redistribution in a nutshell.  Deficit spending is another evil that is related to inflation.  It is inexorably causative.  What that means is that every dollar the government borrows to spend it does so on its name, not on any assets, for it has no negotiable assets.  Thus are those dollars essentially created out of thin air.  As a matter of fact, they are created out of thin air in literal fact more often than not, as the federal reserve bank commonly creates batches of treasury bills with which to swap banks for their (failing) loans, which the federal reserve bank now calls 'assets'.  However, the treasury bills authorize the congress to spend money that was swapped to banks.  So, they loan money to the government and then trade that loan to a bank for other assets which are really debt.  I can't make this stuff up.

Without deficit spending, the war on drugs would not be worthwhile.  The Department of Homeland Security would not be possible.  The war in Iraq would be laughable.  All of those 'mandates' cause deficit spending because 'we have to' and 'think of the children' or whatever.  The problem is that they are enormously costly with little obvious benefit.  The only concern, that it may need to be paid back, is put to rest on the idea that the money is decreasing in value so it doesn't matter.  However, as above, this causes a misallocation of resources.  Money is spent on boondoggles that help a minority of the voters because it can be.  Were no debt spending readily available, as the founding fathers envisioned when they said money shall be of gold or silver, there would be great difficulty in deficit spending as it would require the acquisition through loans of physical gold and silver rather than the mere construction of virtual money by the minting of electrons as is common today.  This would go a long ways towards curbing government spending, as it would be constrained to the tax base at the very least.

The funny thing to me is that we have way, way more 'dollars' floating about than paper currency.  As a matter of fact, there is very little paper currency actually in circulation, because each paper transaction represents money that could not have had a fractional reserve transaction on it so isn't making a bank money.  Further, paper money is expensive to count and handle, whereas electronic money is simplicity itself to count and handle.

Also, a government that has sufficiently tied up the ways and means of its citizens can track their movements, which is invaluable to law enforcement tasked with rooting out drug users, drug dealers, and those who may have seen a naked person under the age of 18, which are apparently the most important problems facing the country today.

Were there free money, there'd be no way to gain such control.  This would mean that crime would pretty much have to involve a wronged party to be discovered, which, in my humble opinion, is a far nicer society than the one we live in.  This is, to me, the greatest evil of the fiat money system, that it can be so easily tracked.

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