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Our economy nearly hit an iceberg. The disaster would've been catastrophic.

Our economy nearly hit an iceberg.  We heard the ice scraping.  We veered out of the way.  Even now we’re still not sure if we’re in the clear.  There could be other icebergs, and along the bow there’s a murmur, a sound not of water, but of something even more terrifying, out of control inflation.

Among some there is a concern, bordering on hysteria, that printing money to stave off the economic crisis has created conditions that will lead to the eventual collapse of the dollar. Printing money is foolish.  Printing money is reckless.  Printing money always leads to out of control inflation.  Always.

But before we start oiling up the rifles and stocking the basement with canned goods, let’s consider what the banks are doing.  Let’s watch the banks.  Banks are rabid to make money.  Banks particularly like to make money through speculation. So do they think the collapse of the dollar is imminent?

What is Inflation?

Most economists agree that adding to the money supply leads to inflation - but this is not gospel.

Banks know this: inflation is a rise in the general level of prices of goods and services over time.  This rise in prices is usually accompanied by a simultaneous erosion in the purchasing power of money.  Put another way, inflation is an upward spiral in prices accompanied by a downward spiral in buying power.

Businesses hate inflation because uncertainty over the future value of money discourages investment.  Labor hates inflation because inflation goads employees to demand rapid wage increases to keep up with prices or face a loss of buying power which is tantamount to a pay cut.

Most economists agree that inflation is fueled by an excessive growth of the money supply.  Since the law of supply and demand determines the value of most things, a country usually prefers to keep its paper money a scarce resource; in other words, the demand for a country’s currency should be greater than its supply.  When the supply becomes greater than the demand the value of the currency drops.

However, the degree to which the growth of the money supply influences inflation has never been accepted as gospel.  Like Economics itself, there are several schools of thought.

What is a Dollar Actually Worth?

Economics is not a hard science like Biology.  It has not been categorized, theorized, empirically tested and set in stone.  Economics is a work in progress, like Psychology or Sociology, not like Math or Physics.  It remains wide open to conjecture; there are disagreements, and what’s more, unfolding events add something new, a wildcard.

The fear about printing money proceeds from several faulty beliefs.  First, that the agreed upon value of a dollar is fixed by some tangible asset.  To put it bluntly, there is a widespread assumption that a dollar is worth something to begin with – presumably something worth a dollar.  It is not.

Fun and Profit with Currency Debasement

The Romans were the first to get the clever idea of debasing their currency.

In the beginning money – coins to be exact – had “specie value”.  They were worth their weight in gold, or silver or copper or some other valuable metal, literally.  The first inflation was brought about by the Roman Emperor Commodus when he debased coins by introducing worthless metals into the alloy.  Nine-tenths of the coins were still gold, but one-tenth was lead.  Not surprisingly, this soon brought about a ten percent rate of inflation.  Later emperors were less transparent about their debasement of the currency which only led to worse inflation due to uncertainty about the true value of the coins.

In spite of the risks, governments have routinely debased their currencies throughout history in an effort to increase the money supply.  In most cases it has led to inflation, but not all.  In some cases consumers have continued to believe in the value of the currency even when they understood that the currency was debased.

Beginning in the 1700’s many countries began introducing bank notes to represent the amount of gold or other valuable metals held in possession.  Pieces of paper are easier to transport than mounds of coins, so this was a sensible solution, “fiat  money”, otherwise known as bank notes (or dollar bills) began to replace coins as a representation of tangible wealth held elsewhere (most likely in banks).  On the other hand, it allowed for mischief.

Let’s Print Some Money!

Some governments can't resist the urge to print money. In Somalia they have plenty of it. But no one's rich.

Governments in desperate need of money, to finance wars or grapple with natural disasters or cover up their own wasteful extravagance, couldn’t resist the urge to print money in excess of what they had in gold reserves.  The South during the Civil War is a perfect example.  Betting that their victory in the war would eventually bring them great wealth from cotton exports, they printed confederate dollars to finance the war, in effect promissory notes against future wealth.  When it was clear that the South was going to lose the war, inflation went through the roof, and then the confederate dollars became worthless.

However, this didn’t stop the US government and others from printing paper money that had no actual basis in wealth.  Ostensibly bank notes were tied to the gold standard – meaning that their value was based on gold held in reserves – but often they painted outside the lines to finance land booms or gold rushes, resulting in a painful cycle of booms and busts in the late 19^th and early 20^th century.

In the 1930’s Franklin Roosevelt decided to end the charade and officially took the United States off the gold standard, switching to a monetary system backed only by the laws of the country.  In a sense this was virtually the same thing the South did during the Civil War, betting that a victory in war, in this case World War II, would infuse a precarious currency with great wealth – betting on the come, as it were.

This time it worked.  With the destruction of Europe and Asia, the United States became the world’s primary repository of wealth and the value of the American dollar soared, fueling the postwar boom which lasted until the 1970’s.

But the fact remained; the US dollar was backed by nothing other than the full faith and credit of the United States government.  The world followed suit, removing their currencies from the gold standard.

As Good as…

Who doesn't want more gold? Gold means stability and reliability. Right?

In abandoning the gold standard the world crossed an important threshold.  Henceforth, money would not be based on anything of tangible worth – it was simply a measure of the people’s faith in a given currency.

The current run up in gold prices is a direct reflection of Americans’ lack of faith in their currency.  Many people think that by buying gold they are buying something that is more reliable than greenbacks.  However, the only reason gold is currently so valuable is because people believe it is.  The amount of gold in the world has not changed, so its value is a matter of speculation.

Arguably, the probability that gold is overvalued (that there is currently a speculative “bubble”) is much greater than the probability that the dollar is losing value.  However, when the value of gold plummets, when the bubble breaks, it will probably not negatively affect the dollar, because the dollar is not tied to gold.  It’s not tied to anything.  A dollar is not actually worth anything, except what people think its worth.

The Fiction of Money

Today, in the new global economy, we have gone even further, not only is our money not actually worth anything, in most cases it doesn’t even exist.

Another faulty assumption that people cling to is the belief that the government is printing money.  Alarmists on the right love repeat this as if it’s fact.  “The government is printing money!  Disaster looms!”

The country is awash in hundred dollar bills! Actually, em... nope.

Actually, in most cases when the Fed wants to increase the money supply, it doesn’t “print” dollars.  Instead, it pushes a few buttons on a keyboard.  Magically, the amount of money available for banks to borrow from the Fed increases.

When banks do borrow (at zero percent interest currently) what changes hands is nothing more than a few numbers on a computer screen.  The banks show an increase in assets on their books with an accompanying liability to the Fed.  No actual money changes hands.  The money doesn’t actually exist, not in tangible form.  The country is not awash in dollar bills.  The money is largely a fiction.

So what do the banks do with all that fictitious money?  Well, the assumption is that they return it to the American economy in the form of lending to businesses and individuals, putting all that largesse into the hands of the people in the form of paper money, which, if it actually happened, might lead to job growth, business investment, and, yes, inflation.

But that’s not what’s happening.

What Would Citibank Do?

Look around, banks are not lending to the American people.  Instead they are speculating, or sitting on the money, driving up their stock prices by showing enormous cash reserves.  When they do invest they are increasingly investing in multinational corporations which are, increasingly, investing in overseas ventures, specifically those offering cheap labor.  In so doing, they are fueling downward pressure on American wages and moving the money offshore.  From an inflationary perspective this means that there will be no upward pressure on wages in the US for the foreseeable future.

We avoided an iceberg. If we spilled your drink, sorry about that.

With no upward pressure on wages and US dollars being diffused throughout the global economy the usual pressures leading to inflation are subdued.

This is not to say that the United States can go on adding to the money supply indefinitely.  Nor is it to imply that there is no danger in having added so much already.  The current temperament in Washington for cost cutting is well reasoned and to be applauded.  The United States cannot continue its spendthrift ways and must make some hard decisions if the country is to retain its position in the world.  But if the issue is the imminent threat of inflation, the fear is probably overblown.

To see how little the fear of inflation is affecting the economy just look at mortgages.  If the banks truly felt that rampant inflation was just around the corner they would refinance fixed rate mortgages at variable rates starting now, with interest rates at 3%.  With the advent of inflation those interest rates could be expected to climb, going from 3% to 5%, and then 8%, 10%, 12%, and with a high degree of inflation, 18%, 22% and higher.

Think about it, what bank would not want to refinance an 8% mortgage at 3% if, within ten years, that mortgage could be expected to rise to 25%?

Yet the banks won’t refinance at all, not even with a variable rate, unless the equity in the home is greater than 20%.

It seems clear that the banks are not speculating on an increase in inflation.

The United States added hugely to the money supply in recent years in an effort to stave off the economic crisis.  That’s a fact.  But having done so, it doesn’t mean the table is set for an even worse crisis.

To wring our hands now over the threat of inflation is like complaining that our drink spilled because the Titanic took a sharp turn to avoid an iceberg.

Clean up the drink and stop fretting.  You avoided a catastrophe.  It could’ve been worse.  ♦

Author and Client:  This article was written by Malcolm Logan for Searchwarp

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Image Credits:

Titanic Sinking, Public Domain; Printing Money, Daily Tape; Roman Coins, Capital Numismatic Group; Money for Sale, Bartez; Prospector, Tony Oliver; Awash in Hundred Dollar Bills, 2bgr8; Avoiding an Iceberg, Kim Hansen