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Transcript

What is inflation?

Inflation has been a hot topic with the prices of goods and services radically increasing over the past few years.

Many news agencies and think tanks talk of inflation in terms of prices going up.

However, what inflation means in economic terms is not simply prices rising.

Inflation is an increase in currency production or a debasement of existing currency.

To understand this, let’s first look at a historical example of debasement.

During the Roman Empire, the Romans used coins made of silver and gold bullion.

These coins were wildly popular because they were valuable precious metals and were widely accepted from the Mediterranean to India and China.

The silver coins, called the Denarius, were especially used by the lower classes as they were convenient for daily transactions.

However, the economic policies of the Roman Government started to undermine the currency’s value with high levels of spending on military budgets, increased taxes, and a massive growth of state bureaucracy.

Sound familiar?

Emperor Diocletian enacted price controls in 301 A.D. to try to stop prices from going up, but that ended up hurting the economy even more with people starting to trade in the black market to avoid the controls.

Diocletian’s unpopularity caused him to abdicate his role, with Constantine taking over.

A new gold coin made of 96-99 percent gold was issued to help reform the economy.

But this improvement did not last as more coins were minted into currency. These new coins had silver plating with a bronze interior.

Over time, the silver-plated coins minted carried even less silver, eventually reaching a point where the coins lost virtually all precious metals content, becoming purely bronze.

This devaluation of the silver currency was part of why the Roman Empire collapsed.

The government, in making the currency become relatively worthless, plunged many into poverty.

This reduction of precious metal content is how inflation occurs through debasement as people demand more of the currency to supplement the lack of precious metal value in each coin.

Today, we face a different kind of inflation with the production of fiat notes and digital dollars.

Instead of debasing the currency through removing precious metal content, we now have a government that adds in new dollars at the demand of the Federal Reserve Bank.

The Federal Reserve essentially creates dollars out of thin air by making purchases of U.S. government securities, debt instruments where the U.S. government says they will pay a higher amount than the face value of the security in the future.

The Federal Reserve is not required to produce anything in exchange for these purchases.

They can just order them and make entries into their books as check purchases, essentially, creating new digital dollars through what’s called “quantitative easing.”

So why is that bad?

Think of it this way.

Imagine you and a friend are alone on an island.

Your friend collects some pineapples, and you collect some leaves.

You tell your friend that the leaves will act as currency for barter, so he should trade you a pineapple for a leaf.

Your friend trades with you, and now he is now down one apple, but up one leaf.

The leaf does not itself have any material benefit to your friend, but he hopes to trade it with you in the future for something.

Now, if you don’t produce anything of value otherwise to trade, then all you have is a net consumption of the pineapple eaten by you, and your friend just has a useless leaf.

While this may sound oversimplified at first, this is exactly what is taking place when the government prints more currency and there is no new value to others being created.

Or, worse, the government makes people even less well-off and harms economic growth through more intervention and regulation after printing.

When a currency is not representing people providing value to each other and is just printed without any market-valued exchange, it inherently devalues the currency and leads to net consumption.

This is why inflation, whether caused by debasing a currency or by printing more of a currency, hurts people generally.

Those who are hurt the most are the middle class and the poor who tend to be on the receiving end of the devaluation.

This economic concept is called the Cantillon Effect.

Just like in our island pineapple example, those who get to use the newly minted currency first get the initial purchasing benefit of consumption while those on the receiving end are stuck with less valuable fiat.

In the wider, modern market, the government, banks, and larger corporations tend to get the initial benefit of printed purchasing power while the rest of us are stuck with a more devalued currency after initial purchases.

In summary, inflation is not just a “rise in prices,” though that is an effect.

Rather, it’s an increase in the currency supply or, debasement thereof, that then leads to higher prices as more currency is demanded to meet the same levels of prior valuation.

If we want to help curtail inflation, we need to end this system of intentional devaluation and free the market from central planning by the Fed.