Understanding Inflation: A Closer Look
Milton Friedman famously stated that “Inflation is always and everywhere a monetary phenomenon.” His assertion suggests that inflation results from an increase in the money supply relative to the demand and supply of goods and services. Thus, rising prices are not the essence of inflation; rather, they are a consequence of an inflated money base.
Inflation, or the expansion of the money supply, is predominantly instigated by the government. It enables the government to fund expenses beyond its usual means without direct taxation. It’s important to recognize that inflation acts as a hidden tax.
Through inflation, the government subtly appropriates the savings of its citizens. In the context of the United States, where the dollar holds a prominent place globally, any increase in the money supply by the U.S. Treasury and Federal Reserve effectively taxes dollar holders worldwide.
The government has two primary methods for expanding the money supply: borrowing from lenders or from the Federal Reserve. The former is a more transparent approach, while the latter is often deemed misleading. Borrowing from lenders involves a clear transaction in the capital market, whereas borrowing from the Federal Reserve can seem as if it conjures money from thin air.
Now, let’s delve into some recent actions taken by the U.S. Treasury and the Federal Reserve.
Monetizing Debt
In late 2008 and early 2009, Federal Reserve Chairman Ben Bernanke created $1 trillion and injected it into the banking system, a move known as QE1. Starting in November 2010, he initiated a program to acquire $600 billion in government Treasuries, referred to as QE2.
But where does the Federal Reserve source the funds to purchase these Treasuries?
The answer is quite troubling. The Federal Reserve simply notes the funds in its ledger, creating the money from nothing to lend to the U.S. Treasury.
This process is known as debt monetization. Essentially, when the Treasury issues debt, the Federal Reserve purchases that debt with newly created money. Such actions lead to an increase in the money supply, which, by definition, constitutes inflation.
Over time, debt monetization diminishes the value of existing dollar holdings, functioning as a tax as the purchasing power of dollar assets declines. Furthermore, the ramifications of these actions can be highly unpredictable.
Turning the World Upside Down
Initially, the Federal Reserve justified QE2 with the aim of lowering interest rates to stimulate borrowing and spending. They hoped to invigorate monetary flow, boost business activity, and enhance job opportunities. However, contrary to expectations, yields have risen instead of falling.
On November 3, 2010, the day QE2 was announced, the 10-Year Treasury yields stood at 2.56%. As of last Friday, those yields had climbed to 3.42%, marking an increase of over 33%. Simultaneously, food and energy prices have soared.
On that same date, oil was priced at about $85 per barrel. Just weeks ago, oil prices surged past $100 per barrel, reflecting a rise of over 17% in less than four months. Additionally, the commodities food price index has surged by more than 27% in the last six months.
While some of the spike in oil and food prices can be attributed to geopolitical tensions in the Middle East and North Africa as well as poor crop yields, the larger issue seems to stem from an infinite expansion of digital monetary credits juxtaposed against a limited resource production capacity. Moreover, since global markets price food and oil in dollars, this situation is turning the world on its head.
According to a recent report from the San Francisco Chronicle, “Global food costs jumped 25 percent last year, according to the UN’s Food and Agriculture Organization, fueling unrest in North Africa and the Middle East.” This turmoil has resulted in political upheavals in Tunisia and Egypt, while Libya teeters on the edge of civil strife. In response to these protests, global leaders have escalated their acquisitions of essential food staples like rice and wheat.
“Egypt this week bought 120,000 metric tons of wheat from France and 115,000 tons from the U.S. Iraq requested 100,000 tons of wheat this week, and Saudi Arabia may procure 275,000 tons of milling wheat,” reported the CME Group Inc.
In a bid to maintain stability, “Saudi Arabia’s King Abdullah allocated an additional 40 billion riyals ($10.7 billion) for housing and increased funding for education and social welfare due to popular uprisings throughout the Arab world.” He also mandated the creation of 1,200 jobs and made permanent a 15 percent cost-of-living adjustment for government employees.
“The World Bank reported this month that 44 million individuals have fallen into extreme poverty since June, consequent to food shortages pushing the UN food-price measure higher.”
The implications of inflating the money supply are intricate and unpredictable. Bernanke’s interventions led to rising food prices, stirring unrest in North Africa. Consequently, oil prices skyrocketed, driven by fears of supply disruptions in the Middle East.
Once again, government interventions have complicated the situation, and, in turn, more measures are likely to follow.
Sincerely,
MN Gordon
for Economic Prism